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6 ETFs for the Second Great Depression

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By now, everything about the economy was supposed to be better again. But even after suffering nearly two long years past the financial crisis, few have any confidence that things are going to get markedly better anytime soon -- and many think the worst may be yet to come. To defend your portfolio against the possibility of such an outcome, you need the right investments that will behave the way you need them to.

What's to come
You'll find no shortage of doomsayers these days. With jobs refusing to materialize in large numbers, the ranks of the unemployed not only hold back economic growth but also put the fear of further layoffs and job furloughs into workers who still have jobs, reducing productivity and increasing stress levels. Meanwhile, with companies hoarding cash and capital investment apparently slowing, concerns about a potential deflationary spiral have grown stronger among many economists.

As fellow Fool Alex Dumortier observed yesterday, believers in a deflationary scenario have a lot of support behind them. The consumer price index has seen only very modest increases in recent months, and it actually fell during 2009. Company inventories have dropped in value, and money supply figures have shown slowing growth or even outright declines, depending on whose data you choose to believe. These arguments don't show that deflation is imminent, but the chances of severe price drops in the near future may be higher than they've been for decades.

This ETF's for you
If deflation is your primary concern, then the right investing strategy can help you preserve your wealth. Here are three main ideas, and some ETFs that should profit from them if they pan out.

1. Lock in fixed income.
No one who owns bonds is too happy with interest rates right now. Not only are historically low rates on Treasuries reducing the amount of income that bond portfolios generate, but they also increase the possibility of future capital losses on bonds if rates rise in the future.

But if deflation strikes, high-quality bonds suddenly rise to the top of the pecking order among investments. Not only do you get your principal back at maturity in dollars that have more purchasing power than they did when you bought them, but you also get modest interest payments along the way. Compare that to falling asset prices, and suddenly those 1% and 2% yields look a lot better.

The bond ETFs iShares Barclays 20+ Year Treasury (NYSE: TLT  ) , Vanguard Total Bond (NYSE: BND  ) , and iShares Barclays Aggregate (NYSE: AGG  ) all stand to do well in a deflationary environment. The Treasury ETF is the purest play, as it doesn't include any corporate bonds at all and therefore doesn't involve any default risk. The other ETFs provide a good mix of bonds, however, that give diversification away from just Treasuries.

2. Grab that dividend.
Stocks generally don't do well during deflationary environments, as customers begin waiting for price cuts that crimp corporate profits. But high-yielding dividend stocks in mature businesses with constant demand may hold up better than more speculative companies that count on rapid growth.

iShares Dow Jones Select Dividend (NYSE: DVY  ) and Vanguard High Dividend Yield Index are two strong ETFs with a host of strong dividend payers. The Vanguard ETF, for instance, owns over 500 dividend payers, including many telecom stocks that have some desirable traits for hard times: not much in the way of growth prospects, but a solid business model with fairly sticky customer relationships. With companies like CenturyLink (NYSE: CTL  ) and Frontier Communications (NYSE: FTR  ) making the most of local markets, investors in this ETF stand to profit as long as they're able to maintain their dividends.

3. Betting against stocks.
Finally, an aggressive deflationary play would be to bet against stocks by using inverse ETFs. Although leveraged bear funds have big problems, you can also find ETFs that merely mimic the negative return of a benchmark index itself. The Short S&P 500 ProShares (NYSE: SH  ) ETF can act not only as a pure bet against stocks but also as a long-short hedge if you decide to focus on dividend stocks.

Hedge your bets?
Of course, some disagree with the deflationary argument, saying that huge levels of government spending suggest an inflationary depression rather than deflation. So to cover your bases, you might not want to invest all your money in ETFs like the ones above. But just considering the possibility of deflation is a sea change for many investors, who've never seen conditions like this before.

Things may not be better yet, but that doesn't mean you can afford to sit and wait. Decide what you believe, and take steps to protect your portfolio accordingly. If you think deflation is a big threat, then using some of these ETF strategies could serve you well.

If you don't own any ETFs yet, you don't know what you're missing. Find out how to get a smart start as an investor with ETFs.

Fool contributor Dan Caplinger hopes for the best and plans for the worst. He doesn't own shares of the companies or ETFs mentioned in this article. The Fool owns shares of and has written covered calls on Short S&P500 ProShares. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy puts on a happy face even when the economy is depressed.

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  • Report this Comment On August 15, 2010, at 5:54 PM, MarionContrarian wrote:

    Your #1 recommendation, "Lock in fixed income" may indeed work well in a deflationary environment, but buying the TLT doesn't guarantee that you'll get 100% of your principle back. You'd be (relatively) better served by buying the actual gov't bonds than the ETF, assuming that you hold to maturity (or sell at the bottom of the interest rate cycle, if you are a market timer).

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