If there’s anything truly timeless on Wall Street, it’s that investors are invariably worried about the wrong thing. Put another way, the real risk to our portfolios is never from the issue du jour in the financial press. Rather, it’s from something no one is focused on and is, therefore, unexpected.

Since last summer, the market has become progressively concerned about the health of the US economy. Any income Investment deemed vulnerable to weakness has sold off. Some have literally imploded before our eyes.

To be sure, there are real pockets of weakness in the US. Nationwide, home prices are now some 16 percent below their 2006 peaks and are falling fast in many areas. Banks are still taking big write downs, with almost surely more to come. Retailers such as Sears are seeing sales contract as consumers pull in their horns.

But, ironically, several key signs of recession still aren’t evident. On the employment front, for example, there have been several high-profile layoffs at big companies. But initial unemployment insurance claims (UIC) are still well under 400,000, the level typically seen in major slowdowns. UIC is the only reliable indicator of broad-based employment conditions because it’s based on hard numbers rather than survey data.

First quarter earnings were the clearest proof yet that many sectors of the economy are still doing quite well. The notable exceptions were industries with any exposure to the collapse of the housing industry and companies with excessive debt made hard to finance amid tightened credit conditions. And to be sure, we’ve seen some wholesale collapses.

For the most part, however, even sectors deemed vulnerable by the market consensus have shone brightly. First quarter earnings at US wireless communications giants AT&T and Verizon Communications were blockbuster. So were results from their arch rival, cable giant Comcast Corp.

And there are even examples of financial companies that appear to be navigating through their sector’s woes. Admittedly, they’re hardly getting credit in the stock market for their efforts. But history shows those that weather the tough times are huge winners on the other side.

This week’s report on first quarter Gross Domestic Product growth is the most encouraging news of all. The Commerce Dept was expected to revise the economy’s growth rate upward from the initially reported annualized rate of 0.6 percent. But the revision to 0.9 percent was considerably more bullish than anticipated and resulted in Thursday’s rally.

The Unknown and the Known

To be sure, there are still risks to this economy. As I pointed out last week, surging oil prices have become progressively contractionary to overall economic growth since they began their surge earlier in the decade. A vicious upward spike at this point would put further strain on consumer spending at a time when many Americans have lost considerable value in their homes and face higher interest payments from adjustable rate mortgages.

There are also still unanswered questions about the US financial system. Namely, how much more in mortgage-backed securities still have to be written off? How much will loan loss reserves have to be increased in coming months to reflect the weakening credit of bank customers? How many more quarters of declining earnings lie ahead? In short, just what is management still not telling us that we’re only going to find out with earnings reports and profit warnings going forward?

Finally, the biggest unknown is just what impact the weakening US economy is having on our trading partners overseas, particularly developing Asia. So far in this slowdown, the gargantuan growth in Chinese demand for everything from steel to copper has far outweighed slacking US demand. That’s the main factor that continues to push resource prices higher.

As my co-editor Yiannis Mostrous and I point out in our weekly advisory Vital Resource investor (www.vitalresourceinvestor.com), the US was 40 percent of the world’s steel demand and 25 percent of its copper demand at the beginning of this decade. China, in contrast, was close to 10 percent for both resources. Today, those percentages are reversed.

The growth of developing markets has ended the once-airtight relationship between prices of vital resources and the rate of growth of the US economy. Before, US weakness alone could bring down resource prices, and so acted as a natural check on their upward momentum. Today, the US economy’s weakness alone has little impact, not surprising since a 4 percent drop in our steel demand now matters less to global supplies and prices than a 1 percent increase in Chinese demand.

The flipside of this is that a slippage in Chinese growth will bring down the house for prices of steel, copper, aluminum, oil and a host of other commodities. That means that if US economic weakness does spread there, global demand and prices for vital resources will come down in a big way. And the stocks of producers will get slammed.

Trying to get a read on China’s health has become the chief pastime of most commodity market observers. And it’s likely to until the US economy cycles out enough for investors to get more comfortable with its recovery. That means we’re going to see a lot more volatility in stocks of companies that produce natural resources. And the same holds true for any stocks that are deemed to be sensitive to the rate of economic growth.

The good news here is that, with so many people focused on the risks to economic growth, they’re well baked into stock prices. Regions Financial is right in the middle of the storm in the nation’s financial system, and it’s likely to increase writedowns and loan loss reserves further when it reports second quarter earnings in July. In fact, with Cleveland-based regional bank KeyCorp’s sharp ramping up of loan loss reserves, the Street consensus is Regions and other similar banks are headed for challenges even with traditional loan portfolios.

It’s hard to argue that Regions isn’t already pricing in a great deal of potential bad news, trading at just 60 percent of book value. It also sells for barely 8 times projected full-year 2008 earnings, which are based on the same sober macro forecast. And it yields more than 8 percent, a rate that was well-covered in a largely surprise-free first quarter.

As the stock’s volatile market action has demonstrated--it touched a new low this week before rebounding slightly--this remains one worried market. And in worried markets, even the cheapest-looking stocks can get a lot cheaper than we anticipate.

The real question, though, isn’t whether the risk of a US recession still exists. As I’ve pointed out above, there are certainly some areas to keep watching. And second quarter earnings will be just as critical to watch. We don’t want to hold anything that doesn’t measure up.

On the other hand, everyone’s now focused on this kind of risk. It’s well reflected in stock prices, even for some companies that have shown no weakness in the face of slower US growth. A good example is Yellow Pages Income Fund of Canada, which reported accelerating growth in revenue and cash flow, particularly from its online advertising operations, yet today trades at close to 52-week lows.

Being Prepared

In contrast, there’s a very real risk that almost no one is focused on now: rising interest rates. After touching an all-time low of less than 3.3 percent in mid-March, the benchmark 10-year Treasury note yield surged as high as 4.14 percent on Thursday, it’s fastest rise in many months.

It’s easy to forget now. But 11 months ago, the benchmark rate pushed above 5.3 percent. The consensus then--readily joined by many bond market luminaries--was that the 10-year Treasury yield had entered a new trading range. The new low end of the range was anticipated to be roughly 5 to 5.25 percent, while the high end was staked out in the neighborhood of 6.5 to 7 percent on the upside.

At the time, the upward swing in the 10-year yield combined with this emerging sentiment set off a near panic in income investments across the board. Investors worried that everything from utilities and real estate investment trusts to bond funds and limited partnerships would soon fall off a cliff because a rising T-note yield made dividends less valuable. And the result was a steep drop in prices.

As a result, few were looking for what wound up happening: A slowing US economy that sent the 10-year yield plunging once more and elevated credit risk as the chief concern for income investors. When the subprime crisis hit, the market was pricing in the risk of rising interest rates, not risks to the ability to pay dividends. Many investors were caught entirely flatfooted and have paid the price.

If you’re going to invest for income, you’ve got to stick around at least long enough to collect the distributions. Trading is also punished by higher taxes; getting the top 15 percent qualified dividend rate depends on meeting the requirement of a minimum holding period. And, of course, one of the most important benefits of holding income stocks is rising dividends, which inexorably push the value of your principal higher and higher--and won’t come through for you if you fail to buy and hold.

Buying and holding income investments means you have to be prepared to accept and guard against credit risk and interest rate risk. Credit risk has certainly been elevated for the past 10 months or so. And those who’ve ignored it have been gored by it. We’ve seen numerous high-yielding investments melt down for lack of cash flow support.

I’m certainly not suggesting anyone lower their defenses now. But there’s a very easy way to deal with credit risk: Stick to distributions that are backed by solid businesses. That means buying companies that are healthy, growing and able to keep paying their dividends even in stressful times, such as we’ve just been through.

The converse is to always avoid buying the highest yield. This piece of advice has been a staple of my presentations to investment conferences for several years, and it continues to serve me well. Simply, no yield is worth beans unless there’s cash flow behind it to keep paying it, and dividend cuts always cut deeply into your principal.

A secure and growing yield of between 5 and 8 percent is always worth more than a shaky yield of 10 percent or more. And if you do shoot for those higher numbers, it’s absolutely critical that you do your homework. That means getting a handle on what makes the underlying business work and what could stress it.

Even focusing on quality and avoiding the obvious risk of the highest yield won’t save you from all the ups and downs of the market. As we’ve seen during the last several months with expectation-smashing communications stocks, negative sentiment can far outweigh great numbers in the short term.

Long term, however, as long as a company performs well as a business, its yield will be secure. That means ultimate recovery of its share price is assured, no matter how bleak the macro picture looks. And if your income portfolio is well diversified between sectors as it should be, odds are you’ll have a lot more winners than losers.

Utilities have stayed solid over the last 10 months. So have high-quality energy stocks, including the Canadian oil and gas producers that have been off to the races since spring began. Solid, high-quality bond funds and preferred stocks have been a place of stability as well.

These winners have gone a long way toward offsetting the underperformers, which surprisingly have included water companies. Note that I address the ups and down of the water sector in the June issue of Utility Forecaster, which will be available to readers at www.utilityforecaster on Saturday, May 31.

Offsetting Rate Risk

In contrast to credit risk, interest rate risk to income investments is generally most acute when the economy is growing. As a result, it must be addressed in a different manner.

Underlying business quality is still important, as is broad diversification between sectors and security types. Rising rates make all dividends less valuable, and therefore put downward pressure on income investments across the board.

The key is offsets. One of these is simply growth in earnings and dividends. This is fairly cheap rate insurance to buy now because much of the public is focused on current yields and pays little attention to the health of underlying businesses and growth potential. And there’s no better defense against credit risk than a growing business.

Growing dividends aren’t always enough to stem the tide when rates are rising sharply. Many will grouse about whether or not government statistics understate inflation. But the fact is we haven’t experienced rapid inflation in this country since the 1970s.

The good news is--if you believe even half of what US government statistics are saying--inflation is rising, but it’s still very much under control. This decade has many things in common with the last period of rapid inflation in the ’70s: an increasingly unpopular military quagmire, a generally despised government in Washington, surging prices for energy and other commodities and yawning deficits. But, to date, double-digit inflation isn’t one of them.

For example, the first quarter growth domestic product (GDP) deflator--which attempts to measure the impact of inflation on growth--came in at an annual rate of just 2.6 percent. To be sure, the monthly consumer and producer price inflation figures have been all over the map, and the core rate excluding food and energy price trends is worryingly high. But, again, we’re still well within the borders of moderation, and certainly very far from what happened in the ’70s.

On the other hand, there are some worrisome portents. As I pointed out above, the US no longer sets the global price for vital resources, so a slowdown here no longer pushes down prices and inflation. Rather, it’s quite possible that rising commodity prices will spark higher inflation, even as the economy slows.

That’s the condition known as “stagflation,” and all of the potential remedies are painful. Killing off inflation means further exacerbating economic weakness and risks recession. Meanwhile, sparking up the economy means risking much higher inflation.

Dealing with potential and emerging stagflation is the problem the Federal Reserve must increasingly wrestle with. And although there have been plenty of public shows of unanimity, the resignation of a top governor this week raises the specter that all may not be so calm beneath the surface.

The Fed’s apparent decision to cut short its recent string of interest rate cuts is likely to prove positive for controlling inflation risk. But as the steep rise in market interest rates--namely the 10-year Treasury note yield--shows, there’s only so much the nation’s central bank can directly control, and it only has so much room in which it can maneuver.

We may or may not see real signs of accelerating inflation in coming months. In fact, it’s still possible US economic weakness will bring down the rest of the world, and commodity prices will follow along with it. That’s why it’s critical to stay focused on the credit risk of the individual companies you own.

On the other hand, there are obviously signs of inflation now, and few are focused on it as a potential risk. That’s a very dangerous combination, particularly because the slightest inflation expectation can send the benchmark 10-year Treasury note yield markedly higher.

As I said, buying only securities issued by high-quality companies is probably the single best way to protect from inflation risk in the long haul, just as it’s the most foolproof way to guard against credit risk. But some sectors are more resilient in the face of rising interest rates and inflation than others.

Commodity producing companies are one such sector. You don’t have to buy into dubious investment programs or penny mining stocks to have a meaningful position in this area. In fact, that often achieves the opposite effect, and you wind up being held hostage to factors such as whether or not a business is legit. Rather, you look to establish positions in solid companies with growing production profiles, such as gold miner Goldcorp and copper/gold/molybedenum play Freeport McMoRan Copper & Gold.

Again, you don’t ever want to overweight your portfolio into any one sector. But a few of these will go a long way toward leavening out the damage to the rest of an income-generating portfolio that’s always caused by a rate spike or inflation scare. And with gold prices breaking back under $900 an ounce recently, gold stocks are also cheaper than they’ve been for a while. Note that Freeport’s molybdenum is a key element in making the kind of steel increasingly needed to drill for oil miles under the ocean floor. It’s also in stretched supply globally.

Energy stocks have also historically been a natural hedge for income investors against upward spikes in inflation and interest rates. Rising oil prices were at the root of inflation during the ’70s. And any inflation spur we see in the next year or two will no doubt be driven by energy as well. The result is energy company profits--and dividends--do tend to keep pace with inflation. And that’s a very important reason why every income portfolio should have some.

Canadian income trusts are ideal for this purpose because of their huge dividends. Trusts hedge a great deal of their output--rather than sell on the spot market--in order to ensure they have the cash to both pay big distributions and run operations. The tradeoff is hedging prevents them from taking full advantage when the spot prices of oil and gas soar, as they have in recent months.

The good news is, over the next year, the best trusts are sure to lock in higher and higher cash flow, as the lower-priced, old hedges come off and are replaced by much higher-priced, new hedges. And with most trusts selling their output for only about $80 per barrel of oil, and their gas at less than $8 per million British thermal units in the first quarter, the upside is staggering.

Outside commodities and energy, there are few--if any--income-generating investments that can actually gain ground when inflation and interest rates are rising. But some have historically kept pace, notably high-yield or “junk” bonds.

These have, of course, gotten crushed in recent months on rising real and perceived credit risk. Since last year, the yield spread between low- and high-rated paper has widened out to 800 basis points. Those spreads today represent an effective cushion against rising rates, provided economic growth picks up as well.

Faster growth may bring inflation, but it also means less credit risk and a drop in the spread. For example, if the 10-year Treasury note yield rises 100 basis points and the Treasury/junk yield spread narrows by 200 basis points, junk bond prices would actually rise by 100 basis points.

There are two good ways to buy junk now and still protect against any further flare up of credit risk in coming months. The first is to buy bonds of lower-rated electric utility companies such as CMS Energy and Sierra Pacific Resources. No industry has the track record of recovering from disaster as utilities, and the sector’s product is absolutely recession proof. Any risk premium they carry in the marketplace should be considered a gift.

The second avenue is Northeast Investors Trust (NTHEX), a diversified open-end, high-yield bond fund run by the same family for more than 40 years. The fund has consistently outperformed in all markets because of its flexibility as a small fund and its focus on individual businesses’ strength. It’s also no-load, has low expenses and has consistently paid a strong cash dividend.

As for everything else, my general advice is to maintain positions, provided the underlying businesses remain solid. And we got the best evidence of that in first quarter earnings reports, which were almost universally solid for Utility Forecaster, Personal Finance Income Portfolio, Canadian Edge and Vital Resource Investor companies.

My only real suggestion would be to avoid long-term bonds, particularly of the Treasury variety. As we’ve seen with the recent volatility in the 10-year T-note, these are basically speculations on interest rate swings, not income investments. That’s fine if you’re a trader. But, as an investor, there’s no yield advantage or upside from a strengthening balance sheet (as there is with a solid corporation) and a lot of downside if rates do keep spiking.

Also, beware of closed-end funds that push out to big premiums to net asset value (NAV). Unlike open-end funds--which always trade right at the value of their assets (NAV)--closed-end funds trade a fixed number of shares on stock exchanges. Their market prices typically swing from discounts (less than NAV) to premiums (more than NAV) and back again, depending on sentiment. If you’re in a fund at a big premium, you’re at risk to potential big drop in principal, even if management does a good job of holding NAV steady.

Speaking Engagements

Be sure to wear a flower in your hair when you venture west to San Francisco. I’ll be heading to “The City” with Neil George and Elliott Gue Aug. 7-10, 2008, for the San Francisco Money Show.

Neil, Elliott and I will discuss infrastructure, partnerships, utilities, resources and energy, and tell you what to buy and what to sell in 2008.

Click here or call 800-970-4355 and refer to priority code 011362 to attend as our guest.