How to Invest in a Volatile Market

Alexander is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Did the Federal Reserve make a mistake with its recent policy announcement? I don’t think so. While there may be some short-term irrationality in the stock market, the long-term picture remains strongly intact.

The economics of asset rotation

Out of all the Federal Reserve, only 3 participants want tightening measures in 2014.  Yet there is almost unanimous support for tightening by 2015. This implies that the bull market in bonds is likely coming to an end.

<img alt="" height="357" src="http://g.fool.com/editorial/images/52154/6-20-13-stocks-pic-1_large.png" width="728" />

Source: Federal Reserve

Based on these fundamentals, the federal funds rate is likely to move up in 2014 to 2015. Some think the federal funds rate will increase prematurely, perhaps as early as 2014. But if economic data doesn’t improve as expected, then 2015 is when the federal funds rate will go up.

<img alt="" height="403" src="http://g.fool.com/editorial/images/52154/6-20-13-stocks-pic-2_large.png" width="713" />

Source: Ycharts

Over the past five days, investors have been fleeing to cash. The PowerShares DB US Dollar Index Bullish Trust (NYSEMKT: UUP) has gained 1.32% in value. The SPDR S&P 500 ETF (NYSEMKT: SPY) has declined by 2.89%. The iShares Barclays TIPS Bond Fund (NYSEMKT: TIP) has also declined by 2.89%. It appears as though investors have had difficulty finding a safe haven.

<img alt="" height="342" src="http://g.fool.com/editorial/images/52154/6-20-13-stocks-pic-3_large.png" width="745" />

Source: World Economic Forum

The reality is that we’re in a form of a debt crisis, but the debt crisis in the United States is fundamentally different from the rest of the world. Coupon values of treasury notes are declining, causing an asset rotation into cash. This is bad for long-term bond investors and could be advantageous for the stock market.

Also, because rising interest rates are deflationary in nature, the dollar will appreciate against other currencies. Historically, currency devaluation in a debt crisis caused a 28% to 75% decline in the value of a currency. Now, these are emotional extremes, and in the context of our situation we need to play a role reversal.

Fundamentally, demand for the dollar should increase in an environment of deflation. This means dollar appreciation, but by how much? Based on the above table, the dollar could appreciate by 28%.

How to position yourself

Going forward, holding onto cash could be advantageous when compared to buying bonds. However, if fixed income must be a part of an investor’s portfolio then it should be done on shorter-dated securities (1-5 years). This minimizes the loss of investment principal. You should also consider avoiding commodities as changes in monetary policy may causing short-term emotional extremes in which commodities like gold, oil, and silver may underperform.

You should look to invest in stocks that trade for a fair price, grow earnings, and pay a dividend. In this case, you have a reasonable entry point, earnings growth should beat inflation, and you can collect some income while everything works itself out.

2 ideas that should work

A certain portion of your portfolio should be dedicated to non-cyclical businesses. Companies that tend to do well in any type of economic environment are generally consumer goods driven. A couple of examples would be Proctor & Gamble (NYSE: PG) and Wal-Mart (NYSE: WMT).

Proctor & Gamble has a strong product portfolio that will always be in demand. It sells everything from Charmin paper, Duracell batteries, shaving cream, soap, and laundry detergent. The company will generally continue to grow earnings, regardless of the economic environment, which should make you feel safe.

It also trades at a 19 earnings multiple and is down by about 9% of its 52 week high. Going forward, investors are hoping it can generate an additional $10 billion in net income from cost cuts by 2016. Currently it earns $10.7 billion in net income, so an additional $10 billion contribution will result in an earnings double. Based on that, its current valuation may make it a bargain.

Wal-Mart is one of the safest stocks available. It's everyday low price model is just what the doctor ordered during trying times.  Investors, who dislike volatility, may find Wal-Mart a good place to park cash.

 It's currently projected to grow earnings by 9.29%, on average over the next 5-years. It's also trading around a 15 P/E multiple, which is reasonable considering its consistency and performance.  Wal-Mart also rewards investors with a 2.52% dividend, which should keep you happy over the long term.

Conclusion

The Foolish long-term investor will remain optimistic about the stock market.  Based on the data, you may avoid bonds and commodities.  You should also expect a continued rally in the dollar against a basket of other currencies. If you dislike volatility, take a closer look at companies like Proctor & Gamble and Wal-Mart.

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Alexander Cho has no position in any stocks mentioned. The Motley Fool recommends Procter & Gamble. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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