The DEFCON Approach To Investing

I recently attended John Mauldin's Strategic Investment Conference, an annual event that brings together some of the best minds in finance and economics. With some two dozen speakers in two and a half days, the word "intense" best describes the proceedings. I came away thinking that the world is not on the brink of crisis but that crisis is an ever present concern. Most could see a bright future, if only we could transition smoothly from the significant, self-inflicted problems we have amassed since the 2008 downturn.

Most of the speakers identified the major financial bubbles currently threatening our economy--from junk bonds to housing prices and the U.S. dollar--but offered few solutions. After all, we are in uncharted waters today, and neither the Federal Reserve nor Congress really knows which way to go. Our world has become so interlinked that no one wants to take actions that could start a currency or trade war. We live not in a world of policy action but of policy reaction. The Fed and the European Central Bank have become firemen, not statesmen.

The current state of the world argues for defensive posturing. The consensus is that we will not restore normal economic growth without some trauma. While the timing of the next crisis is uncertain, history tells us that overstaying in the market is more costly than getting out early. But is it too early? Since the timing, depth and origins of any crisis are uncertain, let's take a chapter out of the U.S. military's playbook for dealing with threats. They use the term DEFCON, which means Defense Readiness Condition or an alert state. For the purposes of your portfolio, think of DEFCON as Defensive Financial Condition:

DEFCON 1--This is where I judge we are today.

• Keep a balance of cash of at least 10%.
• Invest up to 10% in gold (GLD) and silver (SLV) ETFs.
• Set trailing stop-loss orders on your holdings with long-term gains.

DEFCON 2--Volatility breaks out in the markets driven by a buildup of negative events either here or abroad.

• Increase your cash position to 15%.
• Take all your long-term gains; hold off on taking losses until year-end.
• Set trailing stop-loss orders on all your low-dividend/interest-paying holdings.
• Invest up to 15% in gold (GLD) and silver (SLV) ETFs.
• Buy out-of-the-money puts on ETFs that best mirror your remaining exposed positions.
• Buy some inverse ETFs tied to indexes to offset value declines in your holdings. To short stock indexes I recommend the ProShares lineup; for the Dow 30 use (DOG), for the S&P 500 (SH), for the QQQ (PSQ) and for the Russell 2000 (RWM).

DEFCON 3--A panic has begun somewhere that has spilled over into the securities markets.

• Liquidate all low-and no-income equities.
• Keep ready cash at home as well as gold.
• Be patient. Turn off the financial TV shows. Free advice is worthless. Let events play out because corrections involve several levels of action and reaction.

DEFCON 4--The crisis is well under way, with no end is in sight. Central banks are pursuing conflicting goals.

• Go to the mattresses (for example, cash, gold and silver).

Investors who need steady income should be aware that while bonds, preferred stocks, MLPs and REITs also decline in a crisis, they will normally continue to pay out interest and dividends and will be among the first to recover because of their high payouts. Hence, you may opt to ride out the volatility in an income security.

While I have faith that central bankers have learned much about how to handle the next crisis, their first priority will be to protect the banking system and their bosses, i.e., the government. Not investors. When the crisis hits you will hear lots of happy talk designed to calm rather than inform. One former Fed governor at the conference, Larry Meyer, concluded with these encouraging words: "Good luck--you'll need it."

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Richard Lehmann is editor of the Forbes/Lehmann Income Securities Investor newsletter and president of Lehmann Fridson Advisors.