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How to Protect Your Stock Portfolio When Interest Rates Rise

There are ways to play the stock market when interest rates are rising, analysts say, but investors should proceed with caution.

"The market doesn't normally do well with rising interest rates, so a more defensive posture is in order," Bruce Bittles, chief investment strategist at Robert W. Baird, told CNBC.com."

"I think we still have some choppy waters ahead of us over the next six weeks or so," said Larry Smith, chief investment officer at Third Wave Global Investors. "I don't think the market has fully incorporated the fact that the long bond has just gone from 4.5% to 5.20%. That is still a pretty big number relative to where it was just a few months ago."

Subodh Kumar, chief investment strategist at Subodh Kumar & Associates says investors should be prepared for bond yields to continue to influence stocks. "I think the market is trying to decide what's going on," said Kumar. "I think before we can say all of this is done, the 10-year note would have to fall back to 5% and we're still above that."

While most analysts are sticking with their optimistic forecasts for stocks by year-end, many are warning investors to be wary near-term.

Protect What You Have

Bittles suggests investors protect the gains they've already made.

"A stop-loss around 1425 on the S&P 500 (currently around 1530) would make sense," he said. "If it broke past that, you might have to get more defensive and reduce your exposure and not assume continuing to buy dips will work."

Mike Larson, senior interest rate and real estate analyst for the "Money and Markets" newsletter, says the least risky strategy is taking profits on some of your high flyers.

"As bond yields rise, it makes bonds more competitive," he said. "The faster and higher interest rates rise, the tougher it gets for these buyout managers to finance their deals. If anything makes that private-equity bid go away, that could be bad for stocks."

If you are a long-term investor who is looking to put new money to work, analysts say you should focus on sectors that weather higher interest rates well.

Rick Pendergraft, chief investment analyst for the "Investor's Daily Edge" newsletter, believes consumer staples are the way to go.

One of his favorite stock picks is Anheuser-Busch , maker of Budweiser.

"Stocks that do well in a rising interest rate environment are things that people can't live without," Pendergraft told CNBC.com. "People don't cut back on their drinking no matter what the interest rates do."

Other Stock Picks

Pendergraft also recommends CVS Caremark. "This stock isn't interest rate sensitive because the demand for their business will remain constant," he said. "People are still going to buy their prescriptions and drug store products."

Pendergraft does not own Budweiser or CVS.

Dan Genter, chief investment officer at RNC Genter Capital Management, likes large financial companies such as Bank of America and Citigroup.

"This is not a bad environment for them," said Genter. "M&A is a big part of their revenue, which should continue to do well. On a multinational basis, a weak dollar works in their favor."

Genter says oil services stocks should also thrive despite interest rates, especially the offshore deep water drillers such as Weatherford International and Diamond Offshore Drilling.

"There is just a shortage of rigs," said Genter. "You can't get a rig until 2009."

RNC Genter owns Bank of America, Citicorp, Weatherford and Diamond Offshore.

Another way to play the oil services industry is to buy the Oil Services HOLDRs, according to Bill Strazzullo, chief market strategist at Bell Curve Trading. OIH is a basket of eighteen oil services companies. "We feel this will be over $200 a share in the next 12 to 18 months," said Strazzullo.

Short-Term Cash

If you are looking for a place to park cash short-term, Larson recommends the iShares Lehman Short Treasury Bond exchange traded fund.

"This is a low cost option to park money in short-term debt and ride out any further selling in long bonds."

Analysts say knowing which industries to avoid can be equally important when taking higher interest rates into consideration.

"High-priced luxury items like cars and homes are going to suffer in a high interest rate environment," said Pendergraft. "Avoid homebuilders and auto manufacturers if interest rates continue to go up."

"Avoid rate sensitive areas like real estate investment trusts," said Larson. "I think REITs are over-owned and over-valued in this kind of market. Rising interest rates are just another nail in the coffin in the housing industry."

Phyllis Burke Goffney is a news editor at CNBC.com. She can be reached at phyllis.goffney@nbcuni.com.

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