5 Rules for an ‘X-Files’ Market

03/02/2012 9:00 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

Forget the ‘new normal.’ We’re in an era of volatility, with swings from fervent hope to cold terror and back again. But the returns are out there, writes MoneyShow’s Jim Jubak, who also writes for Jubak’s Picks.

Can we just go back to the good old days? The days when stocks went up every year?

When we all talked "buy and hold"? When a 200-point drop in a day in the Dow Jones Industrial Average was unusual? When the challenge of investing in stocks was finding good, well-managed companies, rather than predicting the direction of the dollar or when Greece would default?

Not a chance.

We have, in fact, entered a new era. It’s not the "new normal" forecast by the leaders of Pimco in 2010. And it’s actually more dangerous than the "paranormal" sketched out in January by Pimco’s Bill Gross. Think of it as an "X-Files" economy.

This era is characterized by extreme swings between fear and hope. And we’d better get used to it.

Remember 2011? The year before the current rally? That’s the new era in a nutshell, I’m afraid.

And we’d better come up with strategies for investing through this period. The current reality is, after all, the only one we’ve got.

I’m going to start this column by depressing all of us with the size of the challenge ahead. And then I’m going to give you five ways to change your investing in ways that can, I hope, make this era less painful and more profitable.

The New Unreality?
Remember the "new normal?" It was the phrase bond-fund legend Gross and Pimco CEO Mohamed El-Erian coined back in 2010 to describe the financial world after the 2008 global financial crisis.

Everyone would deleverage to get rid of debt. Consumers would become frugal. Banks could forget profits, since borrowing would go way down. Houses would lose value, and renting rather than buying would be typical.

Oh, and investors could forget about anything much better than a few percentage points of yield on their bonds and sluggish growth in stock prices. A 5% annual gain would seem like nirvana.

I found that downright depressing—not least because it wasn’t obviously wrong.

In January, Gross replaced the "new normal" with what he called the "paranormal." Gross begins with the observation that rather than deleveraging as described in the "new normal" paradigm, most economies have not reduced debt (US and Eurozone consumers are global exceptions), but instead have piled it on.

The world’s central banks are adding debt to their balance sheets—€2.74 trillion ($3.65 trillion) at the European Central Bank alone after the most recent round of bank loans—so they can lend to banks that would otherwise be broke, which can then buy bonds from governments that would otherwise be broke.

This has worked to the extent that the global economy has continued to expand, instead of experiencing a continued recession as everybody cut debt. But the "paranormal" economy has grown past the one danger of the "new normal" with two potentially painful outcomes.

There’s still the previous "new normal" risk of deleveraging and recession. But there’s also now the opposite risk that economic growth, based on global monetary stimulus, will result in runaway inflation and, finally, global financial implosion.

And, yes, as much of a downer as the "new normal" was, as an investor, I find the prospect of the "paranormal" even more depressing.

Partly that’s because Gross’ second risk—that of runaway inflation and global financial implosion—is scarier than a "new normal." Recession isn’t as scary as implosion, and the meager returns of the "new normal" were at least positive. I don’t think I’d make any money during an implosion.

NEXT: Our Swingin’ Future

|pagebreak|

Our Swingin’ Future
Mostly, it’s depressing because the existence of two radically different alternative outcomes—with a decision between them put off into some unspecified future—will create a financial market where a wild swing toward fear of recession is followed by a swing to fear of inflation/implosion, which is then followed by a swing back to a fear of recession. And so on.

What if the actual dynamic of Gross’ "paranormal" economy and financial market looks a lot like the year we just finished? What if 2011, with its wild swings between what we called risk-on and risk-off, is the normal (or paranormal, if you prefer) that we can look forward to until…

Well, until the world has worked off its huge imbalances of debt and cash.

Why is that so much worse than Gross’ description of the "new normal?" Because the kind of volatility inherent in a pendulum swinging between fear of recession and fear of inflation/implosion creates the potential for huge losses, as investors buy high and sell low over and over again.

A steady average of 3% returns in the "new normal" would be bad for anybody trying to reach a financial goal, but it sure beats getting beaten up over and over again.

I don’t know about you, but I didn’t find 2011 much fun as an investor. Trying to navigate through all those market swings was a lot of work, and I don’t have much to show for it.

I’m in the process of finishing my Jubak’s Picks portfolio calculations for 2011—I’m double-checking the data now, and I should have it posted shortly after this column is published. It looks like my returns are lower than, but within hailing distance of, the 2.1% return on the S&P 500 index.

I’ve never been through a year where I did as much selling and buying and selling and buying just to hold my own. I finished the year with 40% in cash, as I played intense defense. I haven’t run a cash position like that since I started this portfolio in 1997.

If 2011 is typical for the new era, I need to develop strategies to cope with more years like this. Otherwise, my fear is that the character of this market will force me into patterns that aren’t particularly profitable—even if they are reasonable reactions to the pain and uncertainties of that "paranormal" economy and market.

I don’t think I need to run through all my reasons for thinking that there’s a danger of a global financial implosion (for example, see my February 13 post "When is a loan not a loan?"), or for thinking that there’s a danger of a global recession from what Eurozone leaders so glibly call austerity, especially if the United States adopts draconian deficit-reduction economics in 2013.

The key characteristic of the "paranormal" market is its tendency to swing rapidly and radically from high to low and back again on macro hopes and fears. In 2011, that tendency was so pronounced that John Murphy at StockCharts.com dubbed this the "Tarzan" market, for the frequency of its wild swings.

Here’s a brief rundown of the bigger moves in the S&P 500 for the year:

  • December 30, 2010 to February 17, 2011—up 6.5%.
  • March 11 to April 29 (the high for the year)—up 4.6%.
  • April 29 to June 15—down 7.3%.
  • June 15 to July 6—up 5.8%.
  • July 6 to August 10—down 16.3%.
  • August 10 to August 15—up 7.4%.
  • August 15 to August 19—down 7.1%.
  • August 19 to August 30—up 7.9%.
  • August 30 to October 3 (the low for the year)—down 9.4%.
  • October 3 to October 26—up 22.1%.
  • October 26 to November 25—down 6.8%.
  • November 25 to February 29 (the current rally)—up 17.8%.

Looking back, August was my favorite month, with three moves of 7% or better between August 10 and August 30.

The total net result of all this volatility, remember, was a return of 2.1% on the S&P 500 in 2011.

NEXT: 5 Ways to Cope

|pagebreak|

5 Ways to Cope
What do you, as an investor, do with a market like that? That’s an especially important question if you believe, as I do, that 2011 wasn’t an aberration but a typical year in Gross’ "paranormal."

Ideally, you’d like to turn that kind of volatility from an enemy to a friend. After investing my way through 2011, I know that’s much easier said than done. But here are five suggestions gleaned from the pain:

  1. If the net return on the "paranormal" market is 2% to 5% annually, any time a swing down presents a 5% yield in a dividend-paying stock (and it otherwise meets your fundamental tests for quality), jump on it.

For example, on August 24—sort of halfway between the August 19 swing down to 1,124 on the S&P 500 and the August 30 swing up to 1,213—Magellan Midstream Partners (MMP), a member of my Dividend Income Portfolio, fell to $54.78. At that price, the master limited partnership units paid a 12-month trailing yield, or return, of 5.6%.

It turns out that the "paranormal" market was headed up from there—although with a detour at 1,099 on the S&P 500 on October 3. On February 29, Magellan Midstream Partners closed at $73.17, and the yield had dropped with the share price increase to 4.34% (even with an increase in cash payouts in the third and fourth quarters that had sent the total trailing 12-month payout to $3.26, from $3.05 in August).

  1. Use buy and sell target prices to make volatility your friend.

In effect, buying when you see a yield above 5% is a strategy for making downside volatility work for you. But you can do the same thing for stocks that don’t pay a dividend (or where the dividend isn’t high enough to make it the primary reason to own a stock).

I bought Freeport McMoRan Copper & Gold (FCX) in my Jubak’s Picks portfolio at $57.63 on December 14, 2010. The stock hasn’t seen $57.63 since. In fact, the highest it’s been is $54 and change on April 6 and again on July 18, 2011.

After watching the stock for a year, I’ve got a buying and selling pattern in mind. When the stock gets down below $40 to $42, I’m willing to buy more.

The stock hit lows well below $40 on October 3 ($29.47), November 25 ($34.17), and December 16 ($36.76). At the recent price of $42.56, if you’d done that, you’d still be underwater to my original purchase price of $57.63, but you’d have a substantial number of shares purchased near $40 that were in the money even at $42.56.

I’d look to sell some shares (at least) if the stock got back close to the $54 it hit in earlier highs. Even at $50, I’d have a 25% profit on some of my shares.

  1. Buy, sell, and buy and sell again—even in long-term positions.

Sure, I want to own Freeport McMoRan for the long term. The stock is a member of my long-term Jubak Picks 50 portfolio because global demand for copper will climb with rising living standards in the developing world.

But if the "paranormal" market is going to give me volatility, then I’m going to use that volatility to trade in and out, and try to lower my basis cost in my long-term buy-and-holdish positions over time.

One of the advantages of owning a stock for a long time is that you get to know its price patterns and to understand how it reacts to macro events. Use what you know.

  1. Find a few stocks, sectors, or markets that are anti-correlated (or at least uncorrelated) with the main market.

For example, Japanese stocks have been seriously out of sync with the global markets throughout the Euro debt crisis. That’s because when the euro is in trouble and the market is in risk-off mode, selling down everything from Sao Paulo to Shanghai, investors are moving money into yen and yen-denominated investments for safety.

If you compare the charts of the iShares MSCI Japan Index (EWJ) and the iShares MSCI Brazil Index (EWZ) exchange traded funds for October 2011, for example, you’ll see that at a point where Brazilian stocks are sinking to a 20% loss, Japanese stocks are holding rock-steady.

You can do even better finding assets that zig when others zag with individual stocks. Chart Japan’s Sanrio (JP:8136) against iShares Brazil, for example.

You’ll notice that the maker of Hello Kitty killed from March through November, beginning to falter only when the current rally started in that month. Since then, you would have done much better in the Brazilian ETF than in the Japanese equity.

  1. You don’t need to find a lot of pairs like this—and in an age of ETFs, you don’t even need to be able to trade in overseas markets to do it—but you should have a few possibilities in you toolbox so that your portfolio doesn’t have to track the overall market volatility when you don’t want it to.

As my example of Sanrio is meant to suggest, in the "paranormal" market, think of yourself as Dana Scully or Fox Mulder. You’ve got to be willing to go the extra mile (at night, with the Smoking Man lurking in the shadows) to find the tools (otherwise known as stocks) that you need.

The profit is out there. For example, in a world where the credit ratings of the United States and France are under pressure, what about the stock markets of countries with improving credit ratings, such as Chile, Colombia, and Indonesia?

Worried about the euro and the dollar? What about putting money into the Norwegian krone with Norway’s Statoil (STO) or SeaDrill (SDRL), with their 4% and 7.4% dividend yields, respectively, that will climb if the krone appreciates against those other currencies?

If substantial real (that is, after subtracting inflation) returns are unlikely in the "paranormal" market, as Gross suggests, then you’ve got to take advantage of differences in inflation rates, currency strengths, credit risk, and anything else you can figure out.

A final word on the role of my Jubak’s Picks portfolios in all this. In this column, I’m advocating some strategies that I can’t execute in these portfolios. These portfolios are binary buy/sell portfolios, for example, so I can’t sell partial positions or lower my basis cost by adding more shares when a pick gets cheaper.

My suggestion now is, as always, to use my picks as tools and suggestions for building your own portfolio.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Polypore International as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio here.

Related Articles on MARKETS

Keyword Image
11 Reasons to Buy Microsoft
11 hours ago

For our latest recommendation, we revisit one of the world's most prominent technology companies, Mi...