It’s Time to go to DEFCON 2

Toni Turner

In a June newsletter article titled ai???DEFCON 1ai???, I surveyed the state of the economy, Fed policy and the securities markets. We saw then, a troubling series of events which promised market volatility at best and a market correction at worst. After the most recent market meltdown, we now know how this is playing out. Cumulatively, the Dow Jones Industrial Average is down 10.1% from its May high. So, the question of the day is, where should investors go from here?

First, to recap events leading up to this decisive turn in the market, it began with the Chinese stock market unraveling and their governmentai??i??s inept handling of the situation. This followed the beginnings of a policy of devaluing the Chinese Yuan, an action which represents an admission that Chinaai??i??s growth plan is not living up to expectations, but I digress. There followed more bad news about commodity prices (copper and oil) and the effects of a strengthening dollarai??i??s effect on corporate earnings and our export sales.

Fed Officials: A Rate Increase is Still Likely This Week

My own personal view is that a correction this year was overdue and the statements of Fed officials that a rate increase at the September 16th meeting is still likely will keep markets volatile. While they wait, maybe theyai??i??ll look at all the negative economic and trade data coming in and realize that there are more important market drivers than Fed policy.

It is widely recognized that Fed policy up to now has driven stock prices to record levels. I speculated earlier in the year that I thought Yellen wanted to talk down the market to head off a major correction, this despite her public position to the contrary. I based this on her not wanting to look like Chairman Greenspan who famously accused the stock market of ai???irrational exuberanceai??? in 1996 and then did nothing.

This is particularly germane this time around since the stock market bubble is so widely attributed directly to Fed policy. The next week will remain uncertain until the Fed meeting concludes and we see if they cave on a rate increase, i.e. does the tail wag the dog, or the dog the tail. For that matter, given the role the Fed has carved out for itself, itai??i??s unclear to me which is the tail and which the dog.

Urgent Warning from Mike Larson on Interest Rates

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There is real uncertainty about the Fed and about whether a rate hike will result in a sea change in the ongoing disconnect between stock market prices and the real world. My bet is that the Fed will cave on a rate increase in September and I donai??i??t give much chance for December. Whatever they decide may give rise to a sustainable market rally.

Given the uncertain short-term outlook, I am recommending to my newsletter readers and advisory clients that they pursue an investment strategy tailored after the U.S Air Force playbook for dealing with threats. They use the term DEFCON, which means Defense Readiness Condition or a state of alert.

Time to Get Defensive

For the purpose of your portfolio, think of DEFCON as Defensive Financial Condition. In my June article I recommended going to DEFCON 1 which included building your cash position to 10% and a 10% position in gold and silver. Also it called for building cash through taking your long term capital gains and setting trailing stop loss orders on your remaining equities.

I now recommend you go to DEFCON 2. At DEFCON 2, you increase your cash position to 15%, take all long term gains, set trailing stop loss orders on all low dividend/interest paying holdings, increase your gold and silver positions to 15%, buy out of the money puts on ETFs that best mirror their remaining exposed positions, and weigh buying some inverse ETFs to offset value declines in their remaining equity holdings.

Given that a cave by the Fed could give us a market bounce, out of the money short term indexed calls would also be a worthwhile speculation.

September promises to be a wild month for the markets. You can also expect that tax selling will begin early this year, so donai??i??t expect a recover until late December with an early advent of the January effect. The DEFCON approach I am advocating is designed to give you an unemotional approach to the uncertainty ahead. The emotional approach, sell everything, is rarely the right answer.

Until next time,


Richard Lehmann is publisher of the Forbes/Lehmann Income Securities Investor newsletter and a columnist with Forbes.Ai?? He is Chairman and CEO of financial advisor Lehmann Livian Fridson Advisors LLC.Ai??