| About: SPDR S&P (SPY)


The stock market bulls are back with understandable swagger.

While it seems like nothing will bring down stocks, downside risks continue to build.

Is it time to give in to FOMO, or are things simply now FUBAR? What is an investor to do?

The stock market bulls are back, and with understandable swagger. After immediately brushing off the once-dreaded Brexit vote, stocks have soared impressively to the upside. In the process, they have finally broken out to new all-time highs last set more than a year ago in May 2015, marking the longest gap in history between stock market highs without a bear market in between. This latest surge has cemented even further the bullish investor perception that absolutely nothing can bring the stock market down.

For more risk-averse stock investors, the recently swift recovery in stocks presents a dilemma. It is time to succumb to FOMO — the fear of missing outon the next leg higher in stocks? Or has the market reached the point where it is simply FUBAR — fouled up beyond all recognition (that's the family-friendly version of this World War II coinage) — and is no longer a risk worth taking?

How Much Have Stock Investors Really Missed Out On?

Indeed, the second longest bull market in stock market history has seemed relentless in its ability to rise to new heights. As a result, it is understandable for investors to feel as though by being out of the market at any point along the way in recent years that they have missed out on something really special. But in reality, even if you were completely out of the U.S. stock market as measured by the S&P 500 Index (NYSEARCA:SPY) since the end of 2014, which is more than a year and a half's worth of time, you really haven't missed out on all that much. In fact, you may have been able to sleep a bit better at night for extended periods along the way versus those that have been fully allocated to the stock market.

Consider the S&P 500 Index since the end of 2014. Through today, you are up nearly +4% on your broad stock allocation, which is definitely a solid result. But all of these gains have come in the last 15 trading days, for this same stock investor had been down -4% on the index as recently as the end of last month. And along the way, this stock investor had to work their way through two extended draw downs in excess of -10%. Put simply, an investor could have exited the stock market at the end of 2014, gone to cash, took a long year and a half nap, and woke up on the first of July to essentially pick up where they left off.

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But is checking out and moving to cash a satisfactory long-term investment solution? Absolutely not. But one of the misconceptions that some stock market bulls mistakenly believe is that investing in stocks is a binary decision. Either you are running full throttle with a 100% allocation to stocks, or you are completely out of the market in cash and hiding away in a mountainside bunker waiting for Armageddon to strike.

No Need To Fear

Fortunately, one of the great things about capital markets is that it provides investors with anything but a binary choice. Instead, the opportunity exists to build a portfolio that is highly nuanced and is designed to alleviate the FOMO while also protecting against the potential risk that markets being FUBAR finally comes home to roost.

The first point in this regard is the following. Stocks are just one of the many uncorrelated to negatively correlated asset classes that are readily available to investors today to build a truly diversified portfolio. Many investors believe that they are truly diversified if they own a stock portfolio that is diversified across size (large, mid, small), style (growth, blend, value) and geography (U.S., international, emerging markets). But such a stock portfolio is not at all diversified, for the correlation of returns across these various stock categories are already very high in a normal market environment and often move to near perfect correlation during periods of market stress. Instead, a truly diversified portfolio is one that blends a meaningful stock allocation with other different asset classes such as bonds, yield securities, precious metals, commodities, currencies, hedge products and even cash.

For when blending your stock holdings with other asset classes that are often move in their own direction regardless of what the stock market is doing at any given point in time, an investor can provide themselves with the opportunity to continuously participate in whatever upside the stock market may have to offer while also protecting against a sharp downside correction in stocks. For often when stocks are screaming to the downside, the capital that is fleeing the stock market will find refuge in one of these various other truly differentiated asset classes.

Let's explore some examples. Some might look outside of stocks and think "hey, I'm diversified because I also own some high yield corporate bonds" (NYSEARCA:JNK). But this raises the first key point. In order to be truly diversified, you must understand the correlation of returns between stocks and any potential alternative asset class. And in the case of high yield corporate bonds (NYSEARCA:HYG), an investor is essentially owning something that looks and behaves much like a stock.

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This does not mean that all yield offerings move in lockstep with the stock market, however. Consider high yield municipal bonds (NYSEARCA:HYD), which have been a remarkably consistent upside performer over the past year during a time when the stock market has been turbulent. The one concern I might highlight here with high yield munis, however, is that the performance has almost been too consistently good, for post crisis market history has frequently shown that any asset class that enters into a steady state rise with virtually no price volatility is often followed at some point by a subsequent stretch of heightened turbulence. But to date, HYD remains remarkably consistent.

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Of course, such true portfolio diversification can cut both ways. Consider master limited partnerships (NYSEARCA:MLPI), or MLPs, which were the bell of the stock market ball during the yield starved post crisis period until oil prices started to collapse back in 2014. Sure, such an allocation provided a differentiated returns experience, but not the kind that investors would consider desirable by any means. And for those that poured into MLPs chasing yield, it has been a tremendously painful experience over the past two years.

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This highlights another important point, which is that fundamental analysis is critically important when selecting low correlated, uncorrelated to negatively correlated asset classes at any given point in time. For true portfolio diversification is not simply adding asset classes simply for diversification sake, but instead selecting the right asset classes that have their own sound fundamental thesis to support respectable risk-adjusted returns on their own at any given point in time.

This is where a category like long-term U.S. Treasuries (NYSEARCA:TLT) has excelled in recent years. Here is an asset class that has a modestly negative returns correlation with stocks over time. In other words, when stocks are falling, U.S. Treasuries are likely to be rising. But on the most part, U.S. Treasuries are moving in their own direction regardless of what the stock market is doing at any given point in time. And with the endless support of global central banks amid a persistently slow global economy coupled with the fact that developed market sovereign bond yields have gone negative across many parts of the world, U.S. Treasuries have enjoyed steadily solid fundamental support over the past decade through today. As a result, they have measurably outperformed U.S. stocks since the end of 2014 including a particularly strong period of outperformance for 2016 thus far.

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Another example would be gold (NYSEARCA:GLD). The much unloved and long downtrodden yellow metal has posted a returns performance over the past decade that is effectively uncorrelated with the stock market. In short, what gold returns on any given day on average is completely independent of what the stock market is doing. With that said, gold has repeatedly shown the demonstrated ability to shift from an overall uncorrelated asset during normal markets to a meaningfully negatively correlated holding during periods of stock market stress. And given the amount of stress that we have seen over the past year and a half, this has helped enable gold to outperform stocks over this time period.

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The Bottom Line

FOMO or FUBAR? The answer is that it simply does not matter. For an investment portfolio that is truly diversified can be structured so that it is positioned to participate if stocks are climbing higher, but it is also positioned to perform well if stocks are tumbling to the downside. And recognizing the fundamental strengths and weaknesses that can exist for any given asset class at any particular point in time, such true diversification enables investors to avoid the perils of market timing by trying to flip a binary switch between owning stocks and not owning stocks, as investors can instead make portfolio allocation adjustments at the margins to incrementally dial up or down risk exposures to a particular asset class at any given point in time. This way, investors can sleep well at night knowing that they need not fear missing out on the next move to the upside in stocks or any other asset class for that matter while also protecting against the reality that underlying conditions in financial markets may truly be fouled up beyond all recognition.

For those that may be interested, achieving the objective of true portfolio diversification is what we do on an ongoing basis on my Seeking Alpha premium service, The Universal. Please join us, or send me a message if you're interested in learning more.

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

Disclosure: I am/we are long TLT, PHYS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I also own a number of selected individual stocks.