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This is the 8th piece in our Positioning for 2012 series. Readers can find the entire Positioning For 2012 series here.

Eric Parnell is the Founder & Director of Gerring Wealth Management, a Registered Investment Advisor based in Chester County, Pennsylvania and serving clients nationwide. Eric founded Gerring Wealth Management in 2005 with the mission to provide clients with personalized investment services at a low cost.

In addition to his work with Gerring Wealth Management, Eric serves as a professor in the Economics and Finance Department at West Chester University teaching courses in Finance, Economics and Statistics. He is a CFA charter-holder. Prior to starting Gerring Wealth Management, Eric served as the Director of Investment Communications for SEI Investments and as an Economist for Moody's Analytics.

Seeking Alpha's Jonathan Liss recently spoke with Eric to find out how he planned to position clients in 2012 in light of his understanding of how a range of macro-economic and geopolitical trends were likely to unfold in the coming year.

Seeking Alpha (SA): How would you generally describe your investing style/philosophy?

Eric Parnell (EP): My investment philosophy is an absolute return focused strategy. The priority when managing client accounts is to first limit the risk of loss. In other words, I seek to minimize the potential for a negative absolute return. I then seek to maximize positive returns within this risk-controlled framework with the objective of generating an annualized rate of return in excess of 10% over a long-term horizon.

The implementation of this strategy includes the utilization of a broad range of asset classes including stocks, bonds, commodities and select other asset categories that have low to negative correlations with one another.

SA: Within equities, are there any particular sectors or themes you are currently overweight or underweight? If so, why?

EP: I have been concentrating equity exposures toward more defensive sectors including consumer staples and utilities since the end of QE2 in June. Since the outbreak of the financial crisis several years ago, the stock market has shown a heavy dependence on monetary stimulus. But once that stimulus goes away, market volatility and economic uncertainty quickly returns.

In an environment without the potential for any further monetary policy intervention, I would likely hold a zero weight to stocks. This is due to the fact that the necessary deleveraging process would have the opportunity to play itself out, which would lead to a period of economic contraction as the excess debt is cleansed out of the financial system. But the potential for aggressive monetary policy intervention such as the announcement of QE3 by the Federal Reserve remains an ongoing possibility, which I refer to as policy risk. In order to protect against this policy risk and the associated explosive rise in stocks, I maintain an allocation to stocks that is proportional to other asset classes in the portfolio.

During periods when the Fed is actively and aggressively engaged in QE, I have typically looked to maintain more broadly based stock exposure through the use of exchange traded funds. Leading among these are the SPDR Mid-Cap 400 (NYSEARCA:MDY) or the iShares Mid-Cap 400 (NYSEARCA:IJH), as I believe the mid-cap area of the stock market provides an attractive meeting point between the higher growth potential typical of small caps along with the relatively stable characteristics of large caps. I then seek to complement these exposures with selected stock names that offer particularly attractive upside. And during periods of greater uncertainty such as today, I seek to manage against the daily volatility of the stock market while still capturing opportunities.

This leads to a strategy that includes mostly individual stock names. I seek to focus these exposures on the least volatile sectors, mainly in consumer staples and utilities. And with the uncertainty emanating out of Europe in the current environment, this includes companies whose revenues are primary generated in the United States such as J.M. Smucker’s (NYSE:SJM), WGL Holdings (NYSE:WGL), Alliant Energy (NYSE:LNT) and CenterPoint Energy (NYSE:CNP) among others. Beyond individual exposures, I will also seek to use the more defensive Consumer Staples SPDR (NYSEARCA:XLP), Health Care SPDR (NYSEARCA:XLV) or Utilities SPDR (NYSEARCA:XLU) in spots for more diversified defensive exposures.

SA: Which asset classes are you overweight? Which are you underweight? Why?

EP: Because of policy risk, opposing forces define the current market environment. If policymakers act with more aggressive monetary stimulus in the coming months, recent economic growth will likely continue for the time being and risk assets such as stocks, commodities (including precious metals) and even U.S. Treasury Inflation Protected Securities (TIPS) are likely to perform well. Agency MBS would also likely perform well since it is the likely focus of any future QE3 program from the Fed.

Conversely, if policymakers, particularly in Europe, continue to delay in addressing the crisis across the region, the economy is likely to slow if not contract in many regions and safe haven categories such as U.S. Treasuries and precious metals are likely to outperform. Given these two divergent outcomes, I am seeking to emphasize those asset classes that stand to benefit from either outcome. These include Gold (GLD, IAU, PHYS), U.S. TIPS (NYSEARCA:TIP) and Agency MBS (NYSEARCA:MBB).

SA: You mention Gold as an asset that is likely to benefit from either outcome. Do you believe gold is a genuine hedge in uncertain markets? If so, how much exposure to it or other precious metals do you have? If not, where are you turning for potential downside diversification?

EP: Gold is one of many low to negatively correlated asset classes that have purpose in uncertain markets. Over time, Gold has been virtually uncorrelated with Stocks, so Gold does provide a genuine hedge for Stocks in the current environment.

But turning this perspective around, Stocks also provide a genuine hedge for Gold. And several other asset classes provide genuine hedges for both Stocks and Gold. This is why I believe that relatively proportional allocations to these and other asset classes are particularly worthwhile to control against risk amid market uncertainty.

Gold is particularly attractive in the current market environment. If we were operating in a climate defined by consistent growth, price stability and steady global currencies such as the late 1980s and 1990s, Gold would have limited appeal even as a hedge. But these characteristics do not define today’s market. Instead, the economic outlook is highly uncertain including the looming threat of crisis, price instability including the potential for both hyperinflation or deflation, and competitive global currency debasement along with the potential destruction of the euro. All of these factors are highly favorable for Gold as both a total return instrument as well as a hedge for other asset classes including stocks.

SA: You mentioned several gold funds earlier. What’s your preferred vehicle to play gold?

EP: While I understand the appeal of actually holding the physical in your hands, my preferred vehicles to establish an exposure to gold is through the SPDR Gold Trust (NYSEARCA:GLD), iShares Gold Trust (NYSEARCA:IAU) or Sprott Physical Gold Trust (NYSEARCA:PHYS), as each track the underlying gold price with limited tracking error and also provide the liquidity to enter or exit positions as needed through exchange traded instruments.

SA: Some describe the current era as “The Great Deleveraging.” Do you agree/disagree, and does this macro consideration affect your investment planning process?

EP: I believe the global economy has reached a threshold where it can no longer sustain the debt it has accumulated over the past several decades. The bills are now coming due, and the transfer of these liabilities to the public sector has delayed the cleansing process. Unfortunately, the longer this deleveraging process is postponed and the more additional debt that is used to help prevent existing obligations from entering into default, the more painful and chaotic the final correction process is likely to be. As a result, this macro consideration has been central to my investment planning process for the last several years and will likely continue to be for some time.

SA: 2010-11 saw a notable rush for the exits from equities and equity vehicles. Is this a cyclical, or secular shift? What would it take to bring them back?

EP: Investor confidence in the stock markets has suffered greatly in the years since the crisis. This is not necessarily due to the sharp stock market corrections we’ve seen along the way. Instead, I believe it’s more attributable to the uncertainty caused by the various policy interventions to address the crisis. While policy stimulus typically drives stock prices higher, investor confidence is not bolstered by a stock market that just goes up. Instead, it is supported by a stock market that makes sense.

Investors are not easily fooled. They see what’s going on in the world all around them. They see a U.S. economy that is chopping along in fits and starts. They see the instability of the European debt crisis and the potential for the outbreak of another global financial contagion. Yet they watch a stock market that switches from plunging toward despair to euphorically floating higher at a moment’s notice and often without any reason. And in recent years these sudden shifts have almost always been due to the initiation of a policy action. This additional unpredictability causes an understandable feeling of distrust in the stock market for many investors, as they are now conditioned to view both sharp corrections and swift rallies with suspicion.

The move away from equities has still not deteriorated to the point of becoming a secular shift, however. But the longer the unpredictability continues, the more entrenched investor distrust will become.

Looking ahead, the key to drawing investors back is a stock market that begins to act in a way that makes sense. Even if it means that stocks are down for an extended period of time, as long as investor have the confidence that the analysis behind their decision making can actually be validated, they will return to the stock market. But as long as policy actions continue to dramatically distort the stock market, investors will continue to stay away even if it’s going up.

SA: That certainly makes sense from a behavioral point of view. In your opinion, are U.S. equities as an asset class currently underpriced, overpriced, or fairly valued?

EP: I would contend that stocks as an asset class are actually overvalued at present. While stocks may appear undervalued on a 12-month reporting earnings basis relative to its historical averages, this must be considered in context, as stocks are undervalued right now for several reasons.

Three key factors influence how much investors are willing to pay for each dollar of earnings – confidence that companies are able to grow earnings, the stability of underlying prices, and the general market uncertainty (i.e. the potential for a sharp contagion style downdraft in stocks). All three of these factors are under stress in the current environment, so investors are willing to pay less for each dollar of earnings than they might otherwise in a more stable market environment. And they may be inclined to pay even less for each dollar of earnings before it’s all said and done if events unfold badly in the coming months.

SA: Inflation or deflation? Growth or recession? Which way is the U.S. economy headed and how will you be positioning clients?

EP: The underlying forces behind the U.S. economy are tilted toward deflation and recession. Consumers and financial institutions spent decades accumulating excessive levels of debt. And these liabilities are not worked off overnight. Instead, this deleveraging process takes time and involves a deflationary reduction in aggregate demand.

However, the persistently aggressive actions by policymakers result in forces that are shifted towards inflation and growth. Policymakers have decided to take an active approach in working to manage the deleveraging process and its associated impact on the economy. Thus, we could just as easily see a period of inflation and growth depending on how stimulus might be applied in the coming year.

This highlights the importance of maintaining a hedged portfolio with an asset allocation emphasizing those categories that can perform well in any number of widely divergent economic scenarios.

SA: Is the U.S. housing market still an issue or not so much anymore? Will prices continue to fall?

EP: While the ongoing crisis in Europe remains the most pressing problem at present, the housing market in the U.S. is still a core issue in its own right. The house is by far the largest asset for most consumers, and it is an asset that they can utilize to support a variety of other consumer and capital expenditures including funding for small business activity. Consumers have been coping over the last few years with a decline in the value of this asset. And as long as the perceived instability of home values continues to overhang the market, it will serve as an ongoing drag on growth.

SA: Do you have exposure to either REITs or residential real estate in client portfolios?

EP: I do not have exposure to REITs or residential real estate at the present time, although I have had positions in the recent past and actively evaluate this area of the market for potential opportunities.

SA: Where do you see Treasury yields in 12 months? Are Treasuries worth buying at current (low) yields? For clients requiring income, where have you been turning in this low yield environment?

EP: The outcome for Treasury yields will depend largely on monetary policy actions over the coming year. If we see a full-blown crisis erupt in Europe, or if the U.S. economy falls back into recession, Treasuries will thrive and we could easily see yields set new lows. However, if policymakers intervene aggressively with more monetary stimulus and the crisis in Europe is contained for the time being, this would be decisively bearish for nominal U.S. Treasuries and yields would likely move higher.

Given the fact that nominal U.S. Treasuries have already had a strong run for most of 2011 and are now a bit stretched at present, I am favoring U.S. TIPS, usually via the iShares TIPS Bond ETF (TIP) as an alternative, particularly since TIPS are better suited to benefit from either of the two divergent outcomes described above. But my interest in nominal U.S. Treasuries would likely be renewed following any prolonged sell-off.

For those clients requiring income in the current low yield environment, I have been recently focusing on Agency MBS (MBB), which provides a significant yield premium versus U.S. Treasuries at a comparable duration while also essentially having the same explicit backing by the U.S. government.

I have also been focusing on selected Utilities Preferred Stocks (XCJ, DRU, SCU, ELA), or exchange traded debt to be exact, that offer high yields but are not exposed to the same extreme volatility that has been plaguing the overall preferred stock market due to its heavy weighting to financials.

SA: What is the ideal asset allocation for someone with a long-term horizon (greater than a decade) and no need to touch their investments? Can investors continue to rely on stocks after the ‘lost decade’ we just experienced?

EP: The notion of buy-and-hold investing is best suited for secular bull markets. These past phases including the periods from 1946-1966 and 1982-2000 that were defined by steady growth and price stability. In such environments, asset classes generally perform with consistency and predictability, which makes any corrective periods much more tolerable for investors to endure.

Today we are in the throes of the most violent stages of a secular bear market. We’ve experienced these markets before from 1929-1946, 1966-1982 and since 2000. What is unfortunate about these periods (including our current one) is that massive amounts of wealth can be vastly diminished in a matter of days. And the asset classes under pressure can change depending on the forces driving the market at any given point in time.

Thus, investors must periodically evaluate their asset allocation mix to make sure that they are not unduly exposed to any particular risks that have surfaced in the rapidly evolving market environment. I am not suggesting in any way that investors should resort to market timing, but we are also not operating in an environment today where investors can simply allocate their capital and forget about their investments for the next ten years. After all, it took stocks a full 25 years to recover their value during the Great Depression. Thus, keeping an eye on markets and staying involved in a highly disciplined way is much better served in today’s environment.

The good news is that investors can continue to rely on stocks along with the variety of other asset classes over the long-term. As mentioned, we’ve been here before in dealing with crisis. This isn’t the first time and it won’t be the last. And while it may not feel this way right now, it is much better that we are actively engaged in dealing with all of the problems and excesses that brought us to this point. The global economy will eventually emerge from this process in much better shape than it was a decade ago, and once it does we will find ourselves at the beginning stages of a new secular bull market. And this will be an exciting time for investors.

As we continue to navigate the challenges of the current market in the meantime, the ideal asset allocation is one that is broadly diversified and hedged across a variety of categories that have low to negative correlations with one another and are suited to perform well regardless of the widely divergent outcomes that might arise in the coming months. At present, these include a proportional blend to high quality defensive U.S. stocks, U.S. TIPS, Agency MBS, precious metals such as Gold and Silver and selected Utilities Preferred Stocks. An allocation to Cash also makes sense in the current environment, as it provides both short-term portfolio stability as well as the flexibility to step in and buy if others end up being flushed out of the market in the coming weeks or months.

Disclosure: Eric is long SJM, WGL, LNT, CNP, XLU, GLD, TIP, MBB, SLV, XCJ, DRU, SCU, and ELA.

Disclaimer: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Source: Eric Parnell Positions For 2012: Getting Defensive With Utilities, Consumer Staples, Precious Metals, TIPS, Agency MBS