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Right now the investment landscape is very similar to the lethal game of Russian Roulette. For those who don’t know what that is, then here is a quick explanation.

In the real life (and death) version of Russian Roulette there is a gun with six empty chambers. One bullet is placed inside an empty chamber before it is spun around. Now you have to put the gun to your head with a 5/6ths chance that you live and 1/6th chance that you die. I’m guessing that very few of you like these odds and would thus not participate in this game.

So what does that have to do with the investing at this time? Well, I think we have about a 1/6th chance of economic ruin. Meaning that all the debt issues around the globe end up creating a depression that takes years to recoup from. And yes, the market would keep sliding and sliding from here.

So that means we have a 5/6ths chance that the economy will slowly and steadily improve leading to higher equity prices. Even though odds are nicely skewed towards a positive scenario does not mean the economic ruin bullet should not be properly heeded. That begs the question…

Why Might We Be Headed for Economic Ruin?

Consider the possibility that all the things we feared were true before the market rebounded in March 2009 are still true.

Meaning we created this giant asset bubble fueled by excessive debt and a day of reckoning was indeed coming. However, the world’s governments worked together to delay that day of reckoning by piling on even more debt. This sparked a temporary stimulus induced recovery in the world economy which helped markets rebound. Now we see cracks in this world recovery theory that makes us wonder if we are going right back to where we started???

I am not saying this theory is true. So please pull your head out of the oven ;-)

But unfortunately, gentle reader, it is a possibility which I think has a 15-25% likelihood of happening (equal to one bullet in a six shooter gun). Unfortunately there are many other investors out there who think that think that half or more of the chambers are loaded with depression bullets. And that sentiment is creating an excess amount of fear that could push US markets lower in the short run even if those fears never become economic reality.

Why Odds Are Better in the Stock Market

The economic news certainly seems all bad of late. However, there have been some bright spots out there including today’s better than expected revision to 2nd quarter GDP. Going back to earlier in the month we see that the Producer Price Index showed that deflation is nicely at bay for now. Both ISM reports (manufacturing and services) were above expectations and in positive growth territory. And private payrolls are adding jobs. Yes, at a slower pace than we might like. But adding jobs is better than subtracting jobs.

What this all means is that economic news is mixed. The double dippers and fear mongers just want to cling on to the negative stuff and there is some out there…but not all. And a lot of what they are clinging to is not reports showing negative activity. Rather it is a stalling out of previous positive trends. Stalling and falling are two very different things. And right now the proof of a double dip is just not there for me. Nor is it there for the vast majority of economists who closely watch all these indicators.

Lastly, the best case for the stock market is that the rates on Treasury bonds have plummeted. This makes the stock market much more attractive by comparison. For example, the 10 year Treasury is only paying a 2.6% yield. Whereas the earnings yield on the S&P 500 is nearly 3X that level at 7.5%. Or how about that the dividend yield on the Dow 30 index is actually higher than the 10 year rate. The last time that happened was when the market bottomed in March 2009. Investors just couldn’t resist the more attractive potential returns in the stock market then…and soon I think they will see the same thing in the current market environment.

2 Investment Strategies to Consider Now

I will lay out 2 strategies that should help you successfully navigate these tricky waters.

1) Prepare for the Worst: Can you afford for the stock market to sink 20-30% tomorrow? We’ll it’s happened before and it could happen again. For folks at or near retirement, it’s a reminder that you shouldn’t have too much of your wealth tied up in the stock market. And remember that stock mutual funds and variable annuities count as part of your stock market exposure. So if you can’t afford to lose that much money in the market, then you should put a larger amount of your net worth into in secured cash savings account. Make sure it is FDIC insured and shop around for the best interest rates because you may be shocked to find how little interest your current bank is paying you.

2) Cautiously Optimistic Stock Investing: As noted earlier, the better odds currently point to a continued improvement of the US economy leading to higher equity prices. With that in mind, you should have a healthy portion of your money in the stock market. You can even do that with riskier smaller cap, high beta stocks to enjoy outsized gains as the market presses higher. But given the tricky world economic landscape, troubles can emerge at any time. So keep the following in mind:

  • “Buy and Hold” Doesn’t Mean “Buy and Forget”: It’s fine to be a long term investor as long as you actively watch your stocks. That doesn’t mean every 12 seconds like a day trader hopped up on Red Bull and cigarettes. However, at times like these you should be checking your positions at least 2-3 times per week. When you see earnings estimates decline is when it’s time to sell.
  • Diversified Portfolio: Don’t have too much money in any one industry and no more than 20% in any individual stock.
  • Decrease European Exposure: It’s been said that the US economy is like the best looking horse at the glue factory. Meaning we have problems, but most other developed nations are looking even worse. That is especially true in Europe. So do consider lowering your allocation to these foreign stocks. Or even US based companies with heavy foreign exposure, especially to Europe. .

Yes, I Am Putting My Money Where My Mouth Is

You better believe that I am heeding this same advice in my personal accounts and those portfolios I run for subscribers at Zacks.com. So for now I am focused on the strongest possibility, which is that the economy will continue to modestly expand and equity prices should be higher down the road. Yet, I do sleep with one eye open and one foot on the ground just in case the economic landscape changes calling for a different course of action.

Disclosure: No positions discussed...but the general sentiment is absolutely being followed in my accounts.

Source: Russian Roulette, Stock Market Style