Leverage High, Look Out Below

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

According to a Bloomberg report, hedge-fund leverage is at its highest level since 2004. At the same time, investors have started taking on more margin debt, which stands at its highest level since early 2008. It seems like the money is flowing into stocks, which should be bullish for equities. Looking at the statistics, however, provides a more sobering view. Here's what you should consider doing.

Perma Bear
While most investors would see the current leverage as a sign of strength, John Hussman of the Hussman Funds reviews the statistics. What he found is that stock margin debt is more than 2% of GDP. That may not sound like a big deal, but this level of margin debt has only been seen three times according to Hussman: “the 2000 market peak, the 2007 market peak, and the intermediate market peak of February 2011 (not a terrible outcome, but still followed by an 18% decline in the S&P 500 over the following 7 months).”

So, the margin debt issue seems like it might not be quite as positive as it would appear at first glance. Some will call Hussman a perma-bear. This may look like an appropriate title now, but it isn't accurate at all. He is a perma-statistician for sure, using history as a guide to the investment decisions he makes, but he isn't always bearish and, at times, he's been called a perma-bull. Regardless of what you call him, he is a brilliant economist with a keen sense of perspective.

There are Still Big Problems
Timothy Ghriskey, the chief investment officer at Solaris Group LLC, told Bloomberg that, “We quickly added more leverage when results with the tax and debt issues were settled.” And that's the problem with all the added debt. The media circus surrounding the fiscal cliff made it seem like THAT was the problem. It isn't.

The really big issues haven't been dealt with. On this front, you are looking at Social Security, healthcare, and the U.S. government's debt levels. Not to mention the mess in Europe which could easily spill over into the rest of the world. None of these things have even been touched in a meaningful way.

No Place to Put Money
Sadly, the Federal Reserve hasn't been helping matters with its low rate policy. It has gone from supporting the market with specific actions (QE1, for example) to offering blanket support that could, if the Fed wanted, last forever (QE-infinity, by some accounts). This has created market distortions that are hard to get a handle on, but clearly have left investors with little option but to take on added risks.

What's an Investor to do?
If you sit down and think about the three other times that investment leverage has been as high as it today, you might be tempted to run for the hills. That, unfortunately, isn't always an option. For example, investors using the income from their holdings to live off of can't just stop receiving dividend payments.

The key is to focus on great companies and understand that you may have to hold them for a while. Here are some great dividend paying companies that are trading at relatively cheap valuation levels, which may provide some downside protection if the markets head south.

DuPont (NYSE: DD)
This chemical powerhouse has seen its shares struggle of late, despite a long history of success and a strong balance sheet. Yielding nearly 4%, now might be a good time to step in. The company was formed more than 200 years ago to make and sell gunpowder. Today, research and development is the core of this giant chemicals company as it focuses on what it believes are mega trends being driven by population growth: agriculture, nutrition, biotechnology, and advanced materials.

Some of DuPont's best known discoveries touch us in our everyday lives, such as nylon, Teflon, and Tyvek. These three products also help to illustrate the breadth of product categories in which the company competes. Add to that the company operates in over 80 countries around the world and it’s easy to see that DuPont isn't a fly by night enterprise. DuPont is, once again, changing its stripes, which is part of the market's concern, but change has always been a part of the company's DNA.

Lockheed Martin (NYSE: LMT)
Lockheed Martin is one of the largest defense companies on Earth, with a scale and reach that is almost mind boggling. Its fingers are in almost every defense pie you can think of, including cyber warfare. Moreover, it is also entwined with U.S. space exploration efforts. The end of the fiscal cliff hoopla provided a small boost to the company's shares, but it still yields nearly 5%.

That makes sense, given that Lockheed Martin will definitely feel the pinch of any military budget cuts that take place, and there is still a push to trim the military. So the company isn't out of the woods yet. That said, the stock's dividend has historically been increased on an annual basis, and while debt is high, it is at a sustainable level. Moreover, we aren't going to stop defending our nation, so funding at some level will continue and Lockheed is well positioned to prosper over the long term.

Walgreen (NYSE: WAG)
Walgreen stock has had a bit of a run since it hit its lows following problems with Express Scripts (ESRX) and its move to buy a part of European pharmacy Boots. Both moves are riskier than management is known for. The Express Scripts issue has been resolved and the business lost during the spat between the two companies appears to be returning. Still some have suggested that picking a pricing fight with a big partner was a bad idea in the first place.

The investment in Boots, with the option to buy the company out completely in the near future, is a bigger overhang. Walgreen is the largest pharmacy in the United States with a brand name and reach that spans from coast to coast. How that translated into the international space, even if the brand used is notable in its markets, is unclear at best.

Still Walgreen is a financially strong company with a long history of dividend increases. Management has historically done an excellent job and now could be a great time to get aboard with the shares yielding nearly 3%.

McDonald's (NYSE: MCD)
McDonald's barely needs an introduction. Since working through a rough patch about a decade ago when management appeared to lose its way, the company has had an impressive growth streak. Change and experimentation have been a key factor in the success. That hasn't changed at all.

A recent same store sales growth miss, however, has gotten some investors concerned. That said, after getting ahead of itself leading into 2012, the stock gave back ground through most of last year. Yielding over 3%, the company is still a world leader in the fast food industry with a healthy balance sheet and years of growth ahead of it as it expands into new markets.

Doom and Gloom
While market watchers like Hussman are calling for doom and gloom, you still have to invest. The four ideas above are all great companies that are at least a little out of favor, which could help limit downside risk if a bear is on its way. That said, you'll be paid to wait for a recovery by companies that are financially strong and have impressive histories of returning value to shareholders.

Yours,

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ReubenGBrewer has no position in any stocks mentioned. The Motley Fool recommends McDonald's. The Motley Fool owns shares of Lockheed Martin and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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