This Rocky Stock Market Requires an All-Terrain Portfolio

Markets Motley Fool

The bulk of U.S. stock gains in this long-running bull market are due to one variable: the expansion of the price-to-earnings ratio.

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Earnings for S&P 500 companies have stagnated since 2014. Stock prices have gone up, however, because the Federal Reserve and other central banks have squeezed all investors to the same side of the risk curve. Stocks, especially high-quality ones that pay dividends, are regarded as bond substitutes; investors now look at the dividends of those stocks and compare those yields to what they can earn in, say, 10-year Treasurys. This strategy will end in tears, as these bond-substitute stocks are significantly overvalued.

Read: World leaders are taking investors down a dangerous economic path

Investors globally are facing major obstacles nowadays. These include:

• The risk of lower or negative global economic growth.

• Inflation (high interest rates), deflation (low interest rates), or a combination of the two (higher interest rates and deflation).

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We don't know which of these extremes is going to show up, or in which order. Despite their eloquence and confidence, financial commentators arguing one or another extreme point of view don't know either. In fact, the more confident they are, the more dangerous they are. Nobody knows.

Read more: The world is becoming desperate about deflation

What's really called for is an "I don't know" portfolio that can handle extremes.

As investors today, we feel something like a traveler preparing to drive across an unknown continent. A look in the rearview mirror tells us we should pick a sports car, and if the road continues to be as it has been, then our trip may be fast and uneventful. But what if the road that lies ahead is rocky, full of potholes, and maybe strewn with giant boulders?

A sports car will not get past the potholes. What we need is a four-wheel-drive, all-terrain vehicle. This monster will not have the speed or the sex appeal of the shiny red convertible, but it will complete the journey. Its position at the finish line will depend entirely on one unknown -- the road ahead. If it is a smooth, unbroken route, then our Land Cruiser will be left in the dust by the Ferraris and Maseratis. But if my prediction is correct, you're going to be mighty glad to have four-wheel drive -- and you might even end up at the head of the pack.

On the surface, the U.S. and global economies appear to be growing, and though growth has been slow, it has been steady. My concern is that demand for goods has been highly inorganic, engendered by central bankers' quantitative easing and government's unsustainable budget deficits.

This is a time for investors to show humility and patience. Humility, because saying the words "I don't know" is difficult for us money manager types; and patience because most assets today are priced for perfection. They are priced for a confluence of two outcomes: low (or negative) interest rates continuing at current levels or declining further, and above-average global economic growth.

Both happening at once is extremely unlikely. Take one away, and stock market indexes are overvalued somewhere between a lot and humongously. (I won't even try to quantify superlatives.)

Vitaliy N. Katsenelson, CFA is the CIO at Investment Management Associates, which is anything but your average investment firm. (Seriously, take a look.) Smitten by this article? Don't let your love remain unrequited. Sign up here to get my latest articles in your inbox. 

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