QE3 more likely now, so this market could swing sharply either way – 401 Advisor (GNK, TNH, SCCO)

Author: Bill Deshurko, 401 Advisor

Covestor model: Dividend and Income Plus

Disclosure: Long JNK, SCCO, TNH

We are somewhat surprised that May did not turn out to be an overall good month for investors. Fortunately we sold two holdings, as their recent price appreciation had lowered their yields to a lower level then we thought desirable  for our portfolio. While we expected to replace the holdings, we have instead held onto cash for the remainder of the month.

As the S&P 500 lost ground in May, we were able to close the gap in relative performance to the S&P 500 since the model’s inception by holding our own fairly well.

For now, we are pretty comfortable with our holdings and cash level. Economic news is showing a deteriorating of the U. S. and global economic conditions. On the positive side, at least for investors, there is an increasing probability of some sort of Fed intervention. For now we’ll call it QE 3, although a more politically correct name for it is certainly forthcoming. As such it seems foolish to take a large bet on either side of the market. A slowing economy could easily precipitate a 20% drop in the market. On the other hand, more Fed intervention could reignite an overextended rally.

If we start down the correction road, I anticipate a drop in prices for high yield securities, which for us would likely trigger a sale of SPDR Lehman High Yield Bond ETF (NYSE: JNK). If that happens we will likely short the S&P 500 with a 15% – 20% allocation to iShares Lehman 1-3 Year Treas.Bond ETF (NYSE: SHY), an ETF that acts as an inverse fund to the S&P 500. In this way we can protect much of our capital and still generate a dividend from 75% or so of the portfolio.

If the Fed announces a QE 3, then current holdings, such as Southern Copper (NYSE: SCCO) and Terra Nitrogen (NYSE: TNH) should benefit from the inflation fears that will come from more intervention.