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This article is in response to a reader who asked what was a good thing to do at the moment. I am reacting to a few themes running through Seeking Alpha, while also formulating a few of my own.

A fair summary of current strategies is:

  • Play safe and stay in cash
  • Be cautious and go for low volatility dividend paying stocks, large cap better than small cap, increasing dividends better again
  • Don't get caught being too cautious because in a stock market rebound, the two strategies above will lead to underperformance

My Thematic

I am considering two themes.

Firstly, my review of current stock valuations strongly point to risk aversion as a primary driver. This is reflected in the high value of bonds, and for the purposes of putting numbers in an analysis, my benchmark is iShares Barclays 20+ Years Treasury Bond ETF (NYSEARCA:TLT). If TLT were to be trading at $100-$105 (instead of $126), the overall stock market would substantially appreciate in value, all else being equal.

All else being equal is of course earnings and earnings estimates. For stocks that I look at on a regular basis, analyst estimates have not changed much, though in aggregate, the folks at S&P suggest a slight trend to the negative. It may be that analysts are holding back, or it may be that the immediate business outlook is not deteriorating all that much at the moment.

While the printed earnings estimates are not all that concerning, there is undoubtedly negative sentiment impacting them. One need only consider the works of institutions (such as ECRI) which are calling a probable recession in the U.S. in the second half of this year, and respected economists (such as Roubini) who are calling a global downturn in 2013. So, while printed earnings estimates are not signaling danger, I think all investors are fearful of a "tipping point" event similar to late 2008 which may result in earnings downgrades.

The Role of Volatility

I have always been drawn to the wise words of a finance professor of mine, who once suggested that price volatility should affect the relative attractiveness of assets. As a general rule, low volatility should attract more money than high volatility. I think this is demonstrated in the current environment, where daily high volatility and low trading volumes appear to go hand in hand.

In the current market, I find a puzzle which might reward some thought: There are numerous "low volatility" stocks which have not been overly impacted by the market turmoil we have endured since 2008. On the other hand, stocks which might be considered "volatile" have been only marginally more volatile between very well defined periods of market turmoil, and have offered excess returns to boot.

As an example, consider Caterpillar (NYSE:CAT) and Altria Group (NYSE:MO) below.

While I may baulk at CAT's volatility post-April 2011, the period between June 2010 and April 2011 appears just fine to me. I am suggesting here a paradigm shift, from a "timing" issue, to a "stock characteristic" issue. CAT has rewarded an investment after a measurable "market turmoil" event. MO, on the other hand, rewards on a consistent basis. This is an example of "trade" and "buy and hold" in the same market.

To exploit returns offered by stocks such as CAT, the requirements are:

  • Keep informed on earnings.
  • Stay out of the stock during measurable period of market turmoil and risk aversion.

Putting it Together

My view is that the current market is suitable for a core/satellite portfolio strategy.

I see stocks which have doubled in the past few years, with very acceptable levels of volatility, and can think of no reason not to invest in them if their business prospects continue to be favorable. These stocks can form a core portfolio.

The satellite part of this strategy involves finding stocks with similar characteristics to CAT, which might be:

  • Sound businesses with an expectation of increasing earnings
  • Exposure to macro risk aversion
  • The effect of risk aversion on stock price shown to have a high explanatory value

To be clear, this involves identifying pure high beta exposure rather than trying to find "undervalued", "mispriced risk", "insider buying/selling" or other stock specific features.

Therefore, a strategy which involves a degree of active management might mean a large part of the portfolio in low volatility, high dividend stocks, and a small amount of money in leveraged options positions in high beta stocks.

The Core

Risk aversion is high and there is an element of measurable turmoil in the market, and therefore, according to my finance professor, a core holding comprising a high proportion of cash and/or low volatile dividend stocks should be considered first. I am happy to heed his advice. I still favor the better performing stocks in the growth dividend category above cash.

It is difficult to better the performance of Power Shares S&P 500 Low Volatility Portfolio ETF (NYSEARCA:SPLV) which has performed credibly in the past few months. Nevertheless if the idea is to form a personal portfolio, then the following select portfolio has displayed a slightly more favourable active return in the interval.

The stocks comprising this select portfolio are:

MKC

McCormick & Co

Food Products

FDO

Family Dollar Stores

Broadline Retailers

MO

Altria Group

Tobacco

ED

Consolidated Edison

Conventional Electricity

HCP

HCP Inc

Specialty Real Estate Investment Trusts

And the relative performance is:

The Satellite

Measurable risk is elevated, but the earnings outlook, at least for the moment, is projected to be quite acceptable. Therefore I tend to the view of wanting to protect my portfolio performance should stocks surge on a reduced risk scenario. That is one where TLT for instance, might reverse to $110 or lower. It is a plausible outcome (maybe in the event of QE3?).

As discussed above, I tend to use CAT as the benchmark. The decision path is:

  • Not to invest in these stocks until our indicators suggest that market turmoil is decreasing, and that TLT is trending down.
  • Only invest where earnings are not downgraded.
  • Use a leveraged instrument, such as options to maximize the upside and limit the downside.

While the risk indicators suggest "not yet", it is worthwhile preparing a list of possible candidates for this strategy. A sample amongst many that fit these requirements are:

TXT

Textron Inc

Aerospace

FLS

Flowserve

Industrial Machinery

URI

United Rentals

Business Support Services

DOW

Dow Chemicals

Commodity Chemicals

AMP

Ameriprise Fin

Investment Services

A

Agilent Tech

Electronic Equipment

RJF

Raymond James

Investment Services

CAT

Caterpillar

Commerical Vehicles & Trucks

GWR

Genesee Wyoming

Railroads

CBT

Cabot Corp

Specialty Chemicals

A comparative graph illustrates the similarities we are looking for.

Taken together, this strategy has exposure to income and possible capital gain which is likely superior to holding an alternative portfolio of cash and bonds. It is also hedged against a surge in the market based on reduced macro risk while limiting exposure in the event of an earnings downturn.

I had a discussion recently where it was suggested to buy a stock and protect it against a doomsday scenario by purchasing puts. My view is that if I was really thinking that a doomsday scenario was a possibility, I would just stay in cash.

I hope that helps.

Disclaimer: The content in this document is provided as general information only and should not be taken as investment advice. The contents in this explanatory paper shall not be construed as a recommendation to buy or sell any security or financial product, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author. The author may or may not have a position in any security referenced herein. Any action that you take as a result of information or analysis on this site is ultimately your responsibility.

Source: Combine Low Volatility And High Beta In This Market