The bear out there

It’s frightening to realize how much events of the past year resemble the start of the 1970s bear market. That monster, which clawed Bay Street and Wall Street for nearly a decade from 1973 to 1982, ripped apart portfolios and cost investors as much as 50% of their savings.

I don’t want to be accused of fear-mongering, but I feel investors must be prepared for the possibility of a similar decline over the next couple of years. We are in the middle of a financial crisis and the ugly truth is that nobody knows what lies ahead.

What makes this economy so tricky, however, is that disaster is by no means certain. For that reason, I think it’s foolish to sell everything in an attempt to time the market. Instead, I recommend an investment strategy that keeps two objectives in mind — first, it keeps you in the market and makes sure that you benefit from the next rebound when it happens; second, it minimizes the damage to your portfolio if things do take a turn for the worse.

Before we get to the details of what you should do, here’s my take on three scenarios that may come next.

Scenario 1:

The best-case scenario is that the global economy achieves what economists like to call a soft landing. In this scenario, the global economy manages to avoid a recession, but growth slows down. As a result, demand for goods and services, including oil and commodities, eases off. The slackening demand brings down inflation and that, in turn, allows central banks to keep interest rates low. If we do achieve this soft landing, stocks will rally, either later this year, or early next year.

Scenario 2:

This is the moderately bad case. In this scenario, the global economy tumbles into recession as it struggles to deal with the U.S. financial crisis and high oil prices. Adjustment is much longer and more painful than in Scenario 1. For stocks, that means things get worse before they get better — and there’s no telling for sure when those better days will arrive.

Scenario 3:

The worst-case scenario would materialize if inflation persists despite a slowdown in economic growth. High inflation would force central banks to raise interest rates. The high interest rates would make mortgages even more expensive, which would be one more blow to an already devastated U.S. housing market. Since U.S. inflation is already hitting 5%, the highest level in two decades, we can’t ignore the possibility of this nightmare. It would resemble what happened in the 1970s, but hopefully be less severe.

Most economists are predicting sluggish growth to linger well into next year, with persistently high commodity prices. This makes Scenario 3 more probable than the other two. So how do you protect yourself from this worst case, but give yourself a chance to prosper if we do achieve a soft landing and stocks rebound? I recommend two strategies:

Stay at home

I think smart investors should tilt their holdings toward Canadian stocks. There are many reasons to do so. For starters, the loonie is strong and our inflation rate is only half of what it is in the U.S. As a result, Canadian interest rates will most likely remain lower than U.S. rates. Lower interest rates are better for stocks.

The Canadian market is particularly attractive right now because it’s rich in energy and natural resources stocks. These stocks constitute a perfect hedge against inflation, since energy and resource prices rise if inflation roars. Look at how the Canadian market has responded to the recent global turbulence. At the time of writing, it’s lost only about 10% of its value. By contrast, U.S. stocks have lost 20% from their peak. Short of getting out of equities altogether (which I do not recommend), Canada would be your best haven if Scenario 3 does come to pass.

One final point in favor of Canadian stocks is that our financial sector remains sound. Canadian banks are not nearly as exposed to subprime mortgages as their U.S. counterparts. They’re paying dividends of 3% or so and those dividends appear fairly secure. Once the short-term turbulence subsides, financial stocks willlikely recover fairly quickly.

Shop for bargains

The second element of my strategy is to invest in “value” funds that look for low-priced, underappreciated bargain stocks. I am a fan of value investing, because I believe value prevails in the long term, regardless of which way the market goes. A value fund is typically 30% less volatile than a growth fund, which makes it much more suitable for uncertain times such as these.

The challenge is finding funds that truly do invest in value situations. Many funds label themselves as value investors, but actually invest in growth stocks or try to blend investing styles. This can be grossly misleading to investors, but many fund managers get away with it.

To find funds that truly are value investors, I conducted a similarity analysis of historical returns and measured the statistical correlation between the monthly returns from various Canadian equity funds and the monthly returns from value and growth indexes. If a fund showed more similarity to the value index than thegrowth index, I concluded that its portfolio includes more value stocks than growth stocks. The funds I’ve listed in Doomsday machines (see below) , all show a strong value tilt. They charge reasonable fees and have delivered acceptable returns over the past three years, even though value has been out of favor in the recent past.

In addition to the funds I’ve listed, I would urge you to take a look at the iShares CDN Value Index Fund (TSX: XCV, MER:0.5%). This exchange-traded fund trades on the Toronto Stock Exchange and is an excellent alternative to a traditional Canadian value fund. It’s been around for less than three years, but I like its low, low costs and its low turnover. I predict that, over the long term, most value managers will be hard pressed to keep up with this fund.

Doomsday machines

These funds all show a strong tilt toward value stocks — which could come in handy if the global economy lurches into recession.