Investors’ total level of margin debt is less than half a percentage point below the record set in July 2007. As the market closes in on all-time highs, these extensive stock bets with borrowed money might bode poorly for Wall Street. Here’s how you can protect yourself if margin starts wreaking havoc on the market.
Big Numbers
According to The Wall Street Journal, margin debt at the end of the first quarter totaled $379.5 billion, just a touch below the record set in July, 2007. The paper points out that margin use has increased almost 30% in a year. While some pundits see this as animal spirits returning to the market, I view it as another reason to be concerned.
Margin is a wonderful tool for increasing returns, but it also amplifies losses. When too many people think margin is a good thing, bad things can happen. Imagine if too many investors got margin calls at the same time. The resulting panic-selling could quickly spiral out of control.
Time to Be Different
While others are leveraging up, I suggest you follow Bill Gross’s advice and start looking to reduce risk. That means taking profits in highfliers and, if you don’t want to hold cash, buying low-beta stocks.
Beta measures a stock’s sensitivity to the broader market. A beta of 1 suggests that a stock will move in tandem with the market, up and down. A beta below 1 means that a stock is likely to move less than the market in either direction. For example, a beta of 0.5 suggests that a stock will rise or fall only half as much as the market’s move.
When the concern is downside protection, low-beta stocks can help you stay invested while hopefully keeping risks to a minimum. Here are a few well-known companies with betas below 0.5:
Cheap Eats
McDonald’s Corporation (NYSE:MCD) is one of the world’s largest restaurant companies. There are over 30,000 locations across almost 120 countries. However, McDonald’s doesn’t take on all of the risk of owning and running a restaurant because about 80% of its storefronts are franchised.
Intense competition in mature markets coupled with some one-off events in emerging markets have led to a same store sales declines of late. That’s not a good sign for a restaurant company, but after a long string of growth, it isn’t unrealistic to expect some sales softness.
McDonald’s Corporation (NYSE:MCD) shares currently yield more than 3% and have a beta below 0.5. With a business that simply can’t be replicated, and a long history of annual dividend increases, conservative investors would do well to consider this food giant.
Health Care Big Wig
Johnson & Johnson (NYSE:JNJ) is a giant in the medical field, with operations in the consumer products, medical devices, and pharmaceuticals arenas. It is as close as you get to a one-stop shop in the health care industry. With a yield of more than 3%, an excellent record of yearly dividend hikes, and a beta below 0.5, this is a good place to hide from a storm.
Better yet, the company appears to be breaking out of a rut. Over the last couple of years, J&J has had to deal with the loss of patent exclusivity in its pharmaceuticals division and manufacturing and recall issues in its consumer business. Both concerns are abating, which suggests the next few years could see solid top- and bottom-line growth.
Adding to the allure here is that fact that most of the company’s products, including drugs, medical devices, and consumer items from soap to Band-Aids, are necessities, not luxuries. In fact, the medical devices group recently purchased a trauma business, increasing the percentage of products that it sells where purchases aren’t a matter of choice.
Trouble in Emerging Markets
The Procter & Gamble Company (NYSE:PG) has a collection of consumer products unrivaled in its industry. Moreover, it has a reputation for being an innovator, often creating the new categories it goes on to dominate. However, it generates most of its revenues from premium products.
These goods have high margins, but can be a rough segment during economic weakness. This niche has also been a liability as the company has started to move overseas. For investors, however, that’s an opportunity, as management has had to retrench in an effort to shore up the company’s growth image.
That’s left the shares with a yield of more than 3%, despite a well-established record of business success. Couple that with a low beta and decades of annual dividend hikes, and now looks like a good time to use P&G to reduce your overall portfolio risk.
Opposite Day
When everyone else is increasing risk, it is time to start pulling back toward safer investments. The three stocks above are good options for remaining invested, but also keeping your portfolio’s risk profile as low as possible. Moreover, McDonald’s Corporation (NYSE:MCD) and JNJ should also be solid picks if you’re concerned about another recession. Such an economic outcome would be less kind to P&G, but that would likely just give you a good opportunity to add to an existing position in the consumer products giant.
Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Johnson & Johnson, McDonald’s, and Procter & Gamble. The Motley Fool owns shares of Johnson & Johnson and McDonald’s.
The article More Danger Signs for the Market originally appeared on Fool.com.
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