Stock Outlook: Capturing Upside While Bracing For Crisis

by: Eric Parnell, CFA

It is a dilemma facing many investors today. They watch a stock market (NYSEARCA:SPY) that shows the persistent tendency to melt higher on many days. This leads to the natural inclination to want to participate in this upside by increasing allocations to stocks. But when rationalizing this decision, the first thought that comes to mind is the fact that the global economy that supposedly drives stock prices still looks unsteady and anemic. And as we've seen on several instances already over the last few years, we are only one disruptive news event away from the stock market cascading sharply lower.

So what is an investor to do? Stay away and potentially miss the stock market upside, whether it makes sense or not, that may continue for the foreseeable future? Or dive into stocks knowing when at any moment another financial maelstrom may unexpectedly send stocks plunging -30%, -40%, -50% or more in a matter of weeks?

Fortunately, the opportunity exists for investors to potentially do both. It's just a matter of dissecting the stock market to find the solution.

The first step in answering this question is railing against some long-standing mantras about stock investing. To begin, buy-and-hold is not the answer in attempting to resolve this question. Neither is broad stock portfolio diversification. This is due to the fact that when the stock market becomes infected by financial contagion, it tends to take virtually everything down with it.

A look at the MSCI All Country World Index (NASDAQ:ACWI) shows why. It would be difficult to get much more diversified than the MSCI ACWI, which includes a comprehensive basket of stocks that capture all major developed and emerging markets around the globe. If you bought and held the ACWI through any of the three major corrective phases since the outbreak of the financial crisis, you took the direct hit from the market pullback ranging anywhere between -20% to more than -50% along the way. For many investors, the potential for another round of losses of such magnitude is simply unpalatable no matter what the gains might be in the meantime.

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Thus, for those who would like stock exposure but want to protect against risk, an alternative approach is required.

Seek and Ye Shall Find

When the stock market has fallen into sharp correction in recent years, we've seen stock individual correlations essentially go to +1. In other words, when the stock market goes down in crisis, it takes pretty much everything with it.

But this does not necessarily mean that every stock is going down the same way. Some stocks have demonstrated the susceptibility to fall by much more than the overall market. Of course, these would be the stocks to avoid for those wishing to allocate to stocks but protect against crisis. Other stocks, however, have shown the propensity to fall by much less than the overall market. And a select few have demonstrated the ability to repeatedly fall by much less, if not even rise, during past periods of economic stress. These are the stocks that merit very close consideration now and going forward.

Thus, for those investors who would like to have exposure to potential stock market upside while at the same time protecting against the risk of sharp, crisis driven loss, it is worthwhile to consider identifying and owning the select group of stocks that have demonstrated the ability to defy much of the massive downside price pressure that comes with the outbreak of crisis. And complementing these select individual stock exposures with asset class categories outside of the stock market that are set to perform well during times of crisis such as U.S. Treasuries (NYSEARCA:TLT), U.S. TIPS (NYSEARCA:TIP), Agency MBS (NYSEARCA:MBB) and Gold (NYSEARCA:GLD) is particularly worthwhile. Such positioning provides investors with the opportunity for additional upside beyond stocks as well as the true diversification against the potential for extreme loss that many investors are seeking in these persistently volatile markets today.

I will be following this article soon with two additional posts that will identify and explore some of the specific names across the stock market universe that have demonstrated the ability to repeatedly hold up well during periods of extreme market stress in recent years.

Disclosure: I am long GLD, MBB, TLT, TIP.

Disclaimer: This post 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.