There’s nothing sexy about gold and Treasury bonds; in fact, most subscribers are likely drawn to our Growth Portfolio. But these hedges and income-paying investments truly shine in uncertain markets.

The European Front

A sovereign debt crisis has been brewing in Europe for close to a year and a half. The crisis originally began in Greece, a nation that had egregiously mismanaged its finances for decades. But the contagion has spread beyond the peripheral economies of Europe. Both Ireland and Greece have accepted bailouts from regional and supranational organizations and Spain and Italy are teetering on the edge.

On Aug. 5, Italy announced that it would accelerate fiscal consolidation measures and introduce a balanced budget amendment to its constitution. The new amendment would require a balanced budget by 2013, a year earlier than initially planned. The move was aimed at calming jittery investors who had driven up yields on Italian government debt; it was also likely a precondition for the European Central Bank (ECB) to purchase Italian bonds in the market.

The ECB on Monday announced that it would provide support for sovereign bonds. Prior to that, the bank had insisted that national governments deal with their problems independently. This about-face has turned the ECB into the eurozone’s lender of last resort, much like the US Federal Reserve.  

Regional bond markets have calmed since the announcement and the yields on Italian bonds have dropped to about 4 percent. Most analysts predict that the ECB will have to purchase at least EUR400 billion worth of bonds to provide bond markets with sufficient support, but the ECB hasn’t set a target.

Thus far, the mere promise of action seems to be enough.

The American Front

The same could be said in the US.

At the end of July, the Dow Jones Industrial Average posted eight consecutive days of losses and narrowly avoided recording its longest losing streak since 1978. On Aug. 2, the S&P 500 dropped into negative territory for the year. The sell-off was driven by weak economic data; although the employment reports were better than expected, gross domestic product (GDP) growth had slipped to a stall speed of less than 1 percent for the first half of the year.

To add insult to injury, ratings agency Standard & Poor’s (S&P) on Aug. 5 cut the rating on long-term US debt from AAA to AA+, though S&P left short-term ratings unchanged. It was the first downgrade of US debt in history and the markets went into a tailspin. On Monday Aug. 7, the Dow Jones Industrial Average lost 634.8 points for a 5.6 percent decline, its worst one-day performance since 2008.

The downgrade seemed to exacerbate worries over a second recession rather than call into question the creditworthiness of the US government. The market moves that day clearly indicated a “risk-off” stance, as equities plunged and yields on Treasuries of all maturities fell. At the same time, the cost of insuring 5-year Treasuries against default rose by a single basis point to 56.21, compared to the two-year high of 64 in late July. The numbers reveal that investors still believe the US government can pay its debts.

Even S&P didn’t warn of a US default. The agency said that the downgrade reflected a polarized political environment in Washington that made it difficult for the US to manage its finances. It’s an assertion that few could to argue against. Since April. S&P had clearly said that a $4 trillion deficit-reduction deal would be necessary to maintain the US’ AAA rating. Since the downgrade, the US has done little to assuage S&P’s concerns; politicians have sought to either shift blame or fault the agency’s math.

As politicians quarreled, the Federal Reserve came to the rescue of the markets. On Tuesday, Aug. 9, Fed Chairman Ben Bernanke announced that the Federal Open Market Committee had decided that no rate hikes would be implemented until mid-2013. Bernanke also said that the Fed would use every policy tool at its disposal to prevent deflation.

As was the case in Europe, these soothing words were backed by no action. Nevertheless, the Fed’s statement pushed the markets into positive territory for the day and opened the door to a third round of quantitative easing.

What’s Next?

We believe another recession is unlikely. Lackluster US GDP growth in the first half of the year was largely the result of weak consumer spending. Consumers were sidelined by high prices for food and energy and deteriorating sentiment. A confluence of unexpected events in the first half all contributed to the uncertainty. Political unrest in the Middle East and North Africa region caused energy prices to spike. Bad weather raised food prices. The March earthquake in Japan disrupted supply chains and drove up prices for many electronic devices and automobiles.

Those were all essentially one-off events, the effects of which have begun to wane. Commodity prices have already begun to moderate significantly, which will support consumer spending in the back half of the year.

Additionally, the negative market sentiment belies a strong performance from corporate America. About three quarters of the S&P 500’s constituent companies beat earnings estimates in the second quarter on tighter cost controls and improving demand. Corporate balance sheets boast large cash positions and low debt levels. Regional data indicates that manufacturing is improving slowly and the Leading Economic Index is on the rise. Although unemployment remains high, we’ve seen significant improvement in jobless claims and private-sector job creation.

But with a general election looming in 2012, it’s unlikely that we’ll hear about the positive attributes of the US economy. Expect a parade of negativity as Democrats and Republicans tar and feather their opponents.

Build a Hedge

The proverbial wall of worry will only come down brick by brick, and equities will be volatile for the next few months. The only positive catalyst for market sentiment would be the conclusion of the general election or the announcement of another round of quantitative easing.

In the meantime, investors should view the current weakness as an opportunity to buy into quality businesses while ensuring that their portfolios remain well hedged.

The US dollar has suffered amid the turmoil, an outcome that has benefited SPDR Gold Trust (NYSE: GLD) and Market Vectors Emerging Markets Local Currency Bond ETF (NYSE: EMLC). SPDR Gold Trust has jumped by more than 21 percent this year. Although Market Vectors Emerging Markets Local Currency Bond ETF’s performance has been essentially flat, a weak dollar will surely boost its performance in the coming months.

The markets have adopted a “how low can they go” posture toward Treasury yields, which are pushing all-time lows across the yield curve. Consequently, we expect further gains in iShares Barclays 3-7 Year Treasury Bond (NYSE: IEI), though the upside will be limited.

Continue to buy all of our Income & Hedges Portfolio names below the prices listed in the table.

A volatility fund provides another way to hedge against a declining market. Our favorite offering in that class of products is S&P 500 VIX Short-Term Futures ETN (NYSE: VXX)–although we are not adding it to our Portfolio at this time.

The Chicago Board Options Exchange Volatility Index, better known as the VIX, tracks the S&P 500’s volatility. This index, which is also called the Fear Index, outperforms when the S&P 500 runs into trouble. When the S&P 500 crashes, the VIX turns in equally large gains.

This exchange-traded note (ETN) tracks the performance of a basket of short-term VIX futures with an average maturity of one month. As a result, it sports a negative correlation to the S&P 500 and performs well when the S&P 500 declines. By the same token, when markets are flat, the ETN’s performance also remains flat.

The fund’s 0.89 percent expense ratio is fairly high, but the fund features little tax exposure and investors only pay capital gains when they sell the fund. This makes the ETN a cost effective hedge.  

Buy S&P 500 VIX Short-Term Futures ETN at current prices.