David Sterman
Serious economic storm clouds have emerged, and when you consider that the S&P 500 is on track for its fourth straight year of gains, a tumble in 2013 is downright plausible. Here's a sage piece of advice: If you own high-quality companies that appear to sport low valuations, hang on to them. It would be unwise to dump them just because you feel that "stocks are too risky" right now.

Instead, provide some protection for your portfolio through a select group of exchange-traded funds (ETFs). These funds provide you with a hedge against broader market pullbacks and can even let you target certain parts of the market that appear especially vulnerable.

The "flight to quality" example
When the market starts to wobble, many investors act predictably. They sell stocks of smaller companies while holding on to their blue chip, large-cap stocks in a move known as a "flight to quality." In such times, you might protect yourself against any broader pressure that the exodus from small caps may bring by buying shares in the Direxion Daily Small Cap Bear 3X (NYSE: TZA). This ETF actually moves in the opposite direction of the Russell 2000 -- a key proxy for small-cap stocks -- and it moves at three times the rate. For example, if the Russell 2000 fell by 5%, then this fund would gain 15%. This fund trades nearly 20 million shares a day, which means many investors now see it as a key arrow in their quiver of investment moves.

The "global crisis" example
Hedging ETFs are also gaining traction because of the bifurcated nature of the global economy. The U.S. economy appears to be doing well, even as troubles in Europe deepen. The primary exposure that U.S. investors have to Europe is through large-cap stocks found in the S&P 500. By some estimates, roughly one-third of all sales generated by S&P 500 firms are in their European divisions.

If you think the U.S. will fare much better than Europe in 2013, then it might be wise to focus your investments on companies that derive most of their revenue domestically. And you can inoculate your portfolio against the global risks that U.S. multinationals face by buying shares of the ProShares UltraShort S&P500 (NYSE: SDS). This is known as a "2X" fund, which means it moves at twice the rate -- in the opposite direction -- of the index you aim to focus upon. In this example, a 5% drop in the export-focused S&P 500 would yield a 10% gain for this fund.


David Sterman

David Sterman has worked as an investment analyst for nearly two decades. He is currently an analyst for StreetAuthority.com
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