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Markets

Time to Cover Your Bases

Stocks aren't about to collapse, but they are risky. Now is the time to go on the defensive with your portfolio.

Maybe your old high school coach told you the best offense is a good defense, or your drama teacher quoted Shakespeare: Discretion is the better part of valor. Wherever you heard it first, take the message to heart now. The lesson imparted by the stock market this summer is to protect your flanks.

From its peak in May through July 31, Standard & Poor's 500-stock index tumbled 4%, and the Nasdaq, 11%. International markets took a more brutal beating. A bounce-back provided some relief. But the market has more demons to exorcise. Persistent inflation jitters, despite occasional reassurance, prolong the concern that inflation fighters at the Federal Reserve will continue to boost interest rates. That, in turn, conjures up fear of an economic slowdown or even a recession.

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Think rates are close to their peak? Worry about the dollar, which could weaken further if U.S. interest rates are too low to attract worldwide investors.

We don't see a long bear market or a recession -- yet. Still, you'd be wise to raise cash or rebalance your portfolio to capture gains from the past few years. With savings accounts paying 4.75%, it's not surprising that money manager Charles Knott, at Knott Capital Management in Exton, Pa., has parked nearly 17% of his clients' portfolios in cash.

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Don't be tempted to put more money into old winners because they're down. Emerging-markets funds and shares of homebuilders, commodity producers and most small-company stocks aren't likely to continue leading the market. You think the bull is old and tired? Until May, small stocks were on a seven-year winning streak. That's tired.

Instead, try bigger companies and defensive stocks, which can better withstand a tough market and a challenging economy. Taking into account such measures as price-earnings ratio, dividend yield and cash flow, large-company stocks might lose another 5% before hitting bottom, while small fry could drop 23%, contends the Leuthold Group, a money-management and research firm in Minneapolis.

Companies with fat cash reserves can calm nervous shareholders with share buybacks or higher dividends. Reynolds American (tobacco), Cleco Corp. (utility) and Verizon (telecom) have plump cash cushions. Look for companies with brands so powerful that they can raise prices (or avoid lowering them) even when the economy slows. One is Diageo, the British spirits company whose brands include Smirnoff, Johnnie Walker and Tanqueray. Or, favor firms whose everyday products are indispensable -- Colgate-Palmolive (toothpaste) and Alberto-Culver (shampoo).

Foreign companies and U.S. firms with large overseas sales stand to benefit as the dollar weakens. Look at Sanofi-Aventis, the world's third-largest drug maker, or Reuters, the British news and financial-information provider.