For those worried about rising interest rates, the self-evident thing to do is concentrate your holdings in less rate-sensitive assets. In environments of rising inflation and rising rates – but yet where there’s still reason to be bullish on the general direction of the economy – the general strategy is to reduce exposure to duration on fixed-income investments (i.e., bonds with many years before the return of cash flow provides breakeven on your initial capital outlay). This usually means reducing exposure to longer-duration bonds. But it can also mean reducing exposure to bond proxies, such as high dividend stocks, like REITs and certain high dividend payers, such as Ford (F), Pfizer (PFE), and ExxonMobil (XOM). While, as a whole, stocks tend to be a lot more volatile than mid-grade bonds, dividend stocks are regularly subject to the same adverse market forces as rates rise. Companies that pay dividends are generally low-growth, mature firms and more dependent on the economic backdrop to generate revenue relative to growth stocks. They also tend to be more leveraged, though they have greater leeway on that front if they're consistently profitable. Certain tech companies like Facebook (FB) and Google (GOOG) tend to be less dependent on certain macroeconomic developments, such as interest rates, inflation, or the price of oil. Therefore, investors who hold the belief that higher rates will reduce the allure of bonds and dividend-paying stocks might move into instruments that might be better suited to the big-picture conditions associated with a tightening of monetary policy. This might include tech stocks and greater use of options to limit downside. One portfolio on the WhoTrades Marketplace that models this approach is up 90% over the past year with just a 13.2% drawdown over the course of this period. (Source: Marketplace Portfolio Page) The portfolio contains several different holdings, but 50% is in just five positions and 80% in just fifteen. Apple (AAPL) and Adobe (ADBE) collectively make up 51% of the portfolio, when including both the securities themselves and additional call options on those two names. SOXL, a 3x daily bull ETF on semiconductors, comprises 8% between owning the ETF and options. A January 2019 260 call and January 2019 200 call on Netflix (NFLX) adds up to 7%-8% of the portfolio. There are additional positions in Mastercard (MA), Google (GOOG)(GOOGL), Visa (V), Alibaba (BABA), Boeing (BA), and Facebook (FB). While the portfolio is purely concentrated in equities and heavily in one particular sector (tech), an economic backdrop that is favorable to this asset mix could lead to market outperformance versus holding a more diversified allocation. The downside is that when the cycle turns the other direction and we have a recession and bear market, being heavily invested toward long equities and in one particular corner of the market can produce heavy drawdowns. The FAANG stocks (FB, AMZN, AAPL, NFLX, GOOG) are rising more than the broader market. This could mean that they are legitimately better companies with stronger competitive advantages. But it could also mean that investors perceive that there’s a lack of opportunity elsewhere in the market for their money. Therefore, they keep piling into companies believed to be the most innovative and most disruptive despite the fact that they’re already quite expensive. When the market tumbles, the expensive stocks could be hit disproportionately if it’s believed that investors were excessively ebullient about their valuations and they return to more normative levels. Based on some measures – particularly as it relates to measures of gross or net output – stocks are the most expensive they’ve ever been. For example, on the basis of gross value added (GVA) – or goods and services output minus intermediate consumption – stocks are the most expensive ever. The same is true when it comes to the “Warren Buffett indicator” – or market capitalization as it relates to GDP. The higher certain stocks rise, especially when their earnings-related multiples increase, the risks associated with holding them increases. This trader uses options on some trades, which helps limit downside. Also, irrespective of the high valuations of some of these companies, it’s fully possible this portfolio reflects a long-term approach of investing in companies likely to do well over the course of decades. For someone with a 30+ year investing horizon – between investment and the time one would hypothetically need the proceeds to fund retirement – there’s likely to be 4-5 recessions and bear markets. Still, even if one obtains a 7% annualized return from this portfolio, that’s a 7x-8x return on one’s money over 30 years. While avoiding drawdowns is always desired, achieving mid-to-high single-digit returns over the long-run is reasonably good performance. Conclusion Virtually all asset prices are valued off of – or at least impacted by – interest rates. In the US and developed Europe, they are in the process of increasing, with the former ahead of the latter. This is a headwind to the valuations of financial assets, particularly if rates rise faster than what’s currently priced in or earnings rise more slowly than anticipated. Even so, there are parts of the market that are likely to do better than others. This includes securities that are less dependent on the overall health of economy to generate revenue. This includes many tech stocks. Companies like Facebook, Amazon, Apple, and Google also have relatively little debt and are less sensitive to higher borrowing costs relative to industries like oil and real estate, which tend to be very sensitive. Structuring bets as options can also limit downside. Naturally there is a cost to this protection, but can be worth it for those who want to potentially participate in the continuing upside in stocks while reducing the risk on its growing downside. This trader’s portfolio on the WhoTrades Marketplace can either be an interpretation of the current circumstances or longer-term bets on innovative, disruptive companies likely to outperform the market over the long-run. Consider following this trader or thousands of others on the Marketplace to check out strategies of interest, track their progress over time, and to generate trade ideas for your own portfolio.