The Secret To Surviving Today's Unpredictable Stock Market

 |  Includes: BAL, FXA, GLD, HYG, JO, MBB, SPY, TIP, TLT, XLU
by: Eric Parnell, CFA

Both the bulls and the bears have a great deal to worry about with today's stock market. And this has likely left many wondering how best to navigate their portfolios through such continued uncertainty. Fortunately, the secret to not only surviving but also thriving in today's unpredictable stock market is to apply one basic fundamental principle.

While the bulls have enjoyed strong returns this summer, this has come with little fundamental support from the global economy. Instead, the recent rally has been largely built on the persistent hopes for more monetary stimulus from the U.S. Federal Reserve (the Fed) and/or the European Central Bank [ECB]. Following the recent advance, stocks are now showing signs of fatigue as they fade away from resistance at their previous April peaks. And the outlook for stocks is challenged to say the least given the uncertainty associated with the presidential election, the fiscal cliff, the ongoing European crisis and the weakening global economy all looming in the months ahead.

The bears are perhaps feeling even more restless. Although they have had a compelling argument for quite some time now on why the stock market should be going lower instead of higher, any attempts at actually trying to short the stock market in a sustainable way has been absolutely treacherous. For the moment, it appears that the bear thesis might finally be coming together, the caprice of a global central banker on any given day suddenly deciding to talk about injecting more monetary stimulus can be more than enough to completely burn any such bearish position completely to the ground. After enduring such pain time and time again over the past several years, bears are understandably tentative to even consider making another run at shorting the stock market any time soon, no matter how much sense it might make.

So what is the typical investor left to do in trying to navigate today's unpredictable stock market? Perhaps the global economic outlook appears too unstable and the potential for yet another crisis outbreak seems too imminent for a market that has come so far, so fast over the last few years to justify being bullish. Perhaps the temptation to short the stock market is quickly overcome by the realization that the next policy speech by a central banker is all that it may take to wipe out the position. Perhaps even stepping aside and taking a neutral stance does not satisfy amid the concern that the stock market may just keep floating endlessly higher, leaving those in cash behind.

With all of these questions in mind, what then is the answer? What will provide our portfolios not only with the best chance to thrive but to also enable us to sleep well at night? Is it to be bullish, bearish or neutral on the stock market? The answer is none of the above.

Instead, the secret to surviving today's unpredictable stock market is to build a portfolio strategy around the following key principle. The stock market is just one of a broad variety of asset class weapons that are available in your portfolio arsenal for working to achieve consistently positive long-term returns while also carefully managing against downside risk along the way.

This is an idea that may not be readily apparent to many investors. After all, financial news coverage on television and in print is so heavily tilted toward the stock market that it leaves the impression that no other ways exist in which to generate an attractive rate of return but to invest in stocks. Many may have the perception that if they are not invested in stocks, they must simply be sitting out on the sidelines rotting away in cash or clipping a meager coupon on a boring U.S. Treasury note. Such misconceptions could not be further from the truth.

Case in point. It would be extremely rare for an investor to feel compelled to explain why they were not fully invested in coffee (NYSEARCA:JO) when it increased by +125% from June 2010 to May 2011, or why they weren't heavily overweighted to cotton (NYSEARCA:BAL) when it exploded +234% from July 2010 to March 2011. Or why they weren't sitting on a sizeable stash of Australian dollars (NYSEARCA:FXA) when they were gaining +17% versus the U.S. dollar from October 2011 to March 2012. Or why they hadn't shifted completely into long-term U.S. Treasuries (NYSEARCA:TLT) when they jumped by +31% in just two months from August to October 2011. In all of these cases, it is unlikely that many market participants even noticed these moves, but an investor may feel strongly compelled to defend and justify exactly why they may not have been fully invested during the +10% rally in the stock market (NYSEARCA:SPY) since the beginning of June. Stocks are only one of many asset classes available to investors today, but rightly or wrongly, they garner nearly all of the focus and attention.

Relying exclusively on stocks is a less than effective way to generate consistent returns while also controlling risk. This is not at all to suggest that stocks should be abandoned altogether from a portfolio strategy. Far from it, as they play a critically important role in the overall portfolio construct. But their allocation should be held in proportion to various other complementary asset class categories in a broadly diversified strategy.

In many respects, stocks are like the driver in a golf bag. It is a heavy hitting club that can drive the ball a great distance, which is its attractive feature particularly to golf fans. But when a golfer takes to the links, it is certainly not the only club that they carry in their bag. Instead, the driver is accompanied by an array of woods, irons, wedges and putters. Each of these clubs plays its own important part and has its own unique purpose to help the golfer succeed when facing the various circumstances they are likely to encounter over a full round.

The same principles apply to portfolio management. By filling a portfolio with an array of categories that include stocks among many other asset classes, an investor will have placed himself or herself in the best possible position to succeed when facing the various challenges and opportunities presented by the overall market at any given point over time.

The following is a brief and simplified illustration to highlight the benefits of this investing mindset and approach over the last several years. Consider two portfolios. One has been fully invested in broad U.S. stocks via the S&P 500 Index since the beginning of the financial crisis. The second has been invested in equal weights to the following seven asset class categories - broad U.S. stocks, utilities stocks (NYSEARCA:XLU), high yield bonds (NYSEARCA:HYG), U.S. Treasury Inflation Protected Securities (NYSEARCA:TIP), agency mortgage backed securities (NYSEARCA:MBB), gold (NYSEARCA:GLD) and long-term U.S. Treasuries. This second portfolio is a diversified investment strategy that includes stocks along with a variety of other diversifying asset classes.

The above chart shows the performance of these two portfolios since the outbreak of the financial crisis in September 2008. Two things immediately stand out. First, the equal weighted diversified portfolio significantly outperformed the stock market over this time period. Second, it did so with considerably less price volatility and downside risk along the way. For example, when the stock market by itself lurched sharply lower, the blended portfolio continued to steadily rise. When the stock market rallied back, the blended portfolio still stayed the course to the upside. This diversified portfolio is one that consists just 14% of broad stocks and another 14% specifically of relatively more price stable utilities stocks. The remaining 72% was allocated to categories other than stocks. Yet it still succeeded in generating an attractive rate of return with considerably less risk.

The equal weighted diversified portfolio illustration outlined above is a basic example of what can be achieved by building portfolios that view stocks in proportion as just one of many asset classes in a broader strategy. It should be noted that while the categories included above proved effective in a blended strategy over the past several years, this does not at all imply that they will continue to do so going forward. Some categories may continue to work, while others may not. Thus, selecting and managing the correct category inputs over time and fine-tuning the allocation percentages along the way are critically important when applying such a strategy. When implemented correctly, such an approach can enable investors to ignore the day-to-day vagaries of the stock market while providing the ability to realize consistently strong returns over time along with the ability to sleep more comfortably at night.

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

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.