This Rocky Stock Market Requires an All-Terrain Portfolio

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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.

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.

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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).

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?

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