Investors are bracing for the possiblity that 2012 gains will be front-loaded
Some strategies include options collars, dividends and sector rotations
Three months' worth of economic recovery and a turbo-charged stock market, both of which came to a fairly abrupt halt in April. That was the story of 2011, and, some worry, the story of 2012 as well.
As such, strategists are working diligently to devise strategies that would help those with a bad case of market deja vu cope with what lies ahead. Friday's weak nonfarm payrolls number, in which the economy created just 120,000 jobs in March, added to that sinking feeling.
Whether it's hedging against a temporary soft patch or a full-blown correction , many investors are looking to make sure they don't get caught sleeping in the same way they did last year.
"All of them tell me the same thing, regardless of what we think the market is about to do — a pullback or a correction — they don't want to sell all their positions and go into cash," says Randy Frederick, managing director of active trading and derivatives at Charles Schwab in San Francisco. "What they're typically looking for is what's the best way to maintain what they have and not get clobbered if we do have a pullback."
Here are five strategies that Frederick and others are employing for the time ahead:
1. Play Defense — and Offense
Frederick advocates using an options collar, a move that employs selling callsto capitalize on upside cheaply, while buying puts that prevent too much downside. Though the hedging strategy limits gains, it also limits losses — something of concern to investors who have capitalized on the bull market run off the October 2011 lows.
"You can put on a collar strategy that goes out one, two, three, four months, however far you're willing to go, at virtually no cost that will protect your downside," he says. "I don't believe the pullback will be as severe or as long as last year. But the patterns that emerged last year are starting to show themselves again."
With the Federal Reserve's latest easing program, dubbed Operation Twist, coming to an end in June, Frederick believes the market will be volatile as traders try to front-run the central bank's position.
"The market has a tendency to react to what's about to happen rather than what is happening," he says. "If you add all those things together it looks like a very good chance at some volatility and correction in equities."
2. Use a 5 Percent Rule
For those who believe any pullback will be shallow — the market is currently off less than 3 percent from its most recent high — then the obvious solution is to buy on weakness.
Strategists at Al Frank Asset Management in Alisa Viejo, Calif., recommend investors look for good companies whose shares have fallen more than 5 percent since the selling began, and add to positions.
"While we never know what will happen in the short run, we continue to think that the climate is favorable for long-term-oriented investors to be adding to their equity exposure," the firm said in its weekly letter to clients. "The economy is growing modestly, interest rates remain at microscopic levels, sentiment continues to be lackluster, valuations are reasonable and not much in the way of corporate profit growth is expected for the first quarter."
The company listed 12 stocks that qualify. Some of the highlights: Newmont Mining , Yamana Gold, Weatherford International, MDC Holdings and Goldman Sachs.
3. Do the Dividends
Dividend stocks, which were all the market rage in 2011 as investors looked for income during the unpredictable market performance, have underperformed dramatically so far this year. Dividend-payers are up just 3 percent so far, while non-payers surged nearly 18 percent in the first quarter, according to Bespoke Investment Group.
But as winter turns to spring and the stock marketstarts looking muddy, investors might want to go looking for income stream again.
"It comes down to why individual investors need to be diversified, so you need to continue to have dividend-paying stocks even though they have underperformed this year," says Beth Larson, principal at Evermay Wealth Management in Washington, D.C. "The market may very well take a breather, but it's hard not to when we had a 12 percent run in the first quarter."
More broadly, Larson advises investors to sit tight during a likely weak earnings season, during which she says "we're watching pretty closely, but we're not making any major changes in our stance."
MLPs Set Record; Rotation is Still Cool
4. Get Income Elsewhere, Too
Dividend-payers are one good way to keep the money flowing while the market meanders, but there are other solid sources too, says Keith Springer, president of Springer Financial Advisory in Sacramento, Calif.
Among them are corporate bonds, preferred stocksand master limited partnerships, which are traded on public exchanges and concentrated primarily in the energy, transportation and real estate spaces.
MLPs had their hottest quarter ever volume-wise to start 2012, generating $6.1 billion through 21 deals, a gain of nearly 30 percent from last year, according to Dealogic.
Springer says such creative thinking offers benefits during what he believes will be a shallow market pullback that eventually will push the Fed into the third phase of its bond-buying program more commonly known as quantitative easing .
"This is the pre-earnings selloff," he says. "The big thing is the market is going to realize that the slow patch in the economy and bad jobs number is actually what the market wants, because that means QE3."
5. Old Reliable Rotation
In trading so far this year, rotation was the name of the game, with the best-performing areas last year lagging in 2012 and vice versa. After just a quarter of activity, the market may be poised for another march of money, this time out of cyclicals and into defensives.
"You shouldn't be getting new naked long exposure. If you're going to buy something now, it needs to be part of a pairs trade or similarly hedged," says Rick Bensignor, chief market strategist at Merlin Securities in New York.
While Bensignor thinks the extent of the selloff probably will be limited to about 100 points on the Standard & Poor's 500 — roughly a 7 percent drop — he sees defensive sectors like consumer staples or telecom as the better bet.
"We're in the eighth inning of the rally," he says. ""We think it's just time to stop with what's worked so far, which is just buy, buy, buy."