Unprecedented Volatility Will Continue to Rock the Stock Market in Advance of a Possible Rebound in Mid-2009

[Editor's Note: With the New Year upon us and in response to the positive feedback we've received from our "Outlook 2009" economic forecasting series has received, Money Morning is taking advantage of the holiday to run several of our most popular installments a second time.]

By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

In the 20 years I’ve been creating stock-market forecasts, I’ve never seen such a contradictory set of forces at work in the markets all at one time. I could just as easily make the case that we’re finally nearing a bottom, as I could that we’re in for protracted downturn punctuated by sharp, quick drops.
The only question in my mind is what shape an eventual recovery will take, for I see three possibilities:

• A “U,” with a slow, methodical reversal that gradually transitions into a market rebound.
• A “V,” with a quick, sharp reversal that marks the start of a powerful rebound.
• Or a sideways “hockey stick,” in which the downward trend ends sharply – but without the immediate upward surge in stock prices that would constitute a strong rebound.

My proprietary analysis and historical precedents both suggest the “hockey stick” is the most probable scenario. At a time when earnings are slowing and all sorts of red flags are flying, there are still too many unknowns to predict a U-shaped or V-shaped rebound.
Therefore, we believe investors will be best served filling their sails with the winds from the world’s most-powerful trends than they will be by trying to catch the intermittent gales. This is a market that will be dominated by large global trends – and the blue chips that follow them – particularly at a time when the so-called “economic cycle” doesn’t matter much.

Position Yourself to Profit

A properly structured and globally diversified portfolio using the 50-40-10 allocation model (50% “base-builder” foundation investments, 40% global growth and income plays and 10% “rocket rider” speculative investments that will perform well in a recovery) we recommend in The Money Map Report – our affiliated monthly investing newsletter – will prove to be an investor’s best friend. And the reasons for that are as simple as they are compelling:

• First, a properly structured portfolio has built in safety brakes that keep us from making overly risky decisions.
• And second, while this allocation model was constructed to minimize our downside in markets such as the one we’re navigating right now, it also positions us to benefit when the rebound eventually gets under way.

During the past year, we’ve repeatedly urged our readers to make sure two other elements are part of their portfolio: Dividend-paying stocks and specialized “inverse funds” that gain when the markets decline.

While dividends are important in any market, they’re downright crucial now because they add to returns during market rallies and help offset losses during market declines. And our commitment to inverse funds was rewarded during the whipsaw month of October: During a month in which the Standard & Poor’s 500 Index lost 16.8%, the Nasdaq Composite Index shed 16.3% and the Dow Jones Industrial Average dropped 13.9%, all 10 of the best-performing exchange-traded funds (ETFs) were inverse funds, which boasted one-month returns ranging from 36.4% to 66.6%, Thestreet.com reported last week.

Now those are admittedly highly remarkable returns – and clearly aren’t the norm. But it does demonstrate the point we’ve been making: It pays to protect y our downside even as you position yourself for gains. And not only do such investments as inverse funds hedge our downside, they smooth out our overall portfolio volatility and help calm roiled waters.

On a more positive note, we’re now getting to the point where true value is finally being revealed, after years of “irrational exuberance.”
But the reality is – and this is hardly new information for most investors – that global markets in general (and the U.S. stock market in particular) remain fragile, and we expect them to remain that way as long as policymakers continue to interfere with their ability to function freely.

Some readers will no doubt take issue with this, believing that the responses of the U.S. Federal Reserve and other central banks have been necessary. While we respect that opinion, we must also point out that the markets have a remarkable history of sorting out problems on their own – if left to their own devices. However, that’s a largely academic discussion that we’ll leave for another time because the government has already charted a course it believes is prudent.

Even if the world’s central bankers get their act together, the damage has largely been done. What’s more, the various bailout packages – especially the $700 billion U.S. banking bailout – while well intentioned, are almost certain to have more than a few unanticipated consequences.

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