What If?

What if this is just a bear market rally and we tumble another 30, 40, 50%?

What if the economy has bottomed, but things don’t really get better for years?

What if the worst is behind us and we start a new generation of growth and prosperity?

If you are 100% confident that you know which of these scenarios is correct, then you are just kidding yourself. The economy and the stock market are simply too complex for anyone to know with such exact certainty. Meaning that not you, nor me, nor Cramer, nor Buffet, nor anybody has this one down pat.

The best we can do is roll through all the “What if?” scenarios. From that we will discover the tell tale signs of which case it will be. Then align our portfolios to maximize profits in that environment. And yes, we can make profits in each and every one of these environments. So, let’s get started.

What If This Is Just a Bear Market Rally?

This is the worst case scenario for the economy and society as a whole. But with trillions of dollars in bad loans and derivatives still looming out there, then we have to assume it’s a real possibility.

Here are the signs to look for:

• More Banking Trouble: This could come in many forms. But if the government’s stress tests were not adequate or there are more bad loan boogeymen looming about, then we are right back where we started with this mess.
• Accelerating Jobless Claims: Weekly report of new jobless claims starts growing again instead of shrinking as it is now. The unemployment rate looks like it will reach around 10-11% when given the current picture of the economy. It’s not good a sign if we start shooting past that mark.
• Deflation: Meaning the cost for goods start getting cheaper. It sounds nice on the surface, but it’s a deadly economic disease that took hold of the U.S. during the Great Depression. It also spelled disaster in Japan during the 1990’s which they call the “Lost Decade”.
• Runaway Inflation: The reason the government pumped in so much money was to fight off a deflationary spiral. The risk on the other side is that all that extra money creates runaway inflation. Normal inflation is around 2-3%. If you see it creeping up to 5%+ then that could signal things getting out of hand.
• General Economic Weakness: There are a number of key economic indicators to look out for. Since consumer activity accounts for 70% of the economy, then deteriorating retail sales is a very bad sign. Also watch manufacturing activity and sentiment indicators. If they continue to tick down instead of the recent modest improvements, then it spells trouble.

Clearly this kind of environment would result in renewed panic and a tumbling market. Here is how to profit in this environment:

• Sell all small cap, aggressive or speculative stocks: These stocks go down first…and they go down the most.
• Short the Market: I believe the best way to do this is with inverse ETFs that allow you to profit as the market goes down. There are also “Ultra” inverse ETF’s that can give you extra exposure to amplify your potential profits (and potential losses if you guess wrong). As noted above, small caps will fall more than the general market. Thus, you may want to use an ETF like the UltraShort Russell 2000 (TWM). Or you can just do the UltraShort S&P 500 (SDS).
• IF you are going to own any stocks, then they need to be the bluest of blue chips in defensive industries like food, healthcare, utilities etc.
• Nothing wrong with having a lot of cash on hand.

The odds of you seeing these signs clearly and perfectly timing your way into the proper trades is very low. Just realize that it’s better to be a shade late to the party, than not show up all. That should put you in the right frame of mind.

What if Things Don’t Really Get Better for Years?

Here we have the scenario where the economy doesn’t get any worse…it just doesn’t seem to get any better either. The signs to notice this predicament are easy. Essentially all the indicators of the economy (GDP, retail sales, manufacturing etc) just get stuck at a the recent low levels and don’t improve.

The market, however, can follow two very different paths during these times. And each requires radically different tactics to be successful.

Path 1 - Range Bound Market: This would entail the market, just like the economy, going basically nowhere for an extended period of time. We often call this a range bound market as it just trades within a narrow 10-15% band.

These markets are actually easy to profit in. That’s because most companies will not be producing earnings growth. But the few that are will attract investor attention and rise in price. You will find these stocks by concentrating on the best stocks in the best industries. The best industries are those with the healthiest earnings outlooks (easily found with the Zacks Industry Rank). And then you pick the stocks with the best earnings outlooks within those industries (using the Zacks Rank for stocks). Also in this environment, you shouldn’t try to be too aggressive. Concentrate on mid-cap and large-cap stocks which provide a bit more safety.

Path 2 - Volatile Market: Here you have a market that keeps misreading economic signals. You will see big 20-30% run ups on renewed hopes of economic improvement. This is followed by an equal sized downturn as people discover that the growth prospects were just a mirage. At the end of the day the market goes nowhere like Path 1, it just keeps flying above and below that breakeven level.

This environment is trickier, but can be tamed. You just need to apply market timing with a dash of common sense. If the market tumbles and it seems overdone, then buy up good stocks like noted above. When the rally gets overextended and signs of economic growth are missing, then take your profits. Rinse and repeat as many times as needed.

What if We Start a New Generation of Growth and Prosperity?

This is the one we all hope for, but fear is too good to be true after all the recent devastation. Yet it is possible that the coordination of government actions around the globe have thwarted a 2nd Great Depression and that we can start to enjoy growth above current conditions.

Here we have the inverse of the first scenario. Meaning that we hear less and less about banking troubles. The unemployment rate will start heading lower. Inflation stays in a normal 2-3% range. Consumer and manufacturing indicators start showing improvement and GDP numbers start coming in +2% or better.

Now as you have heard many times before, the stock market predicts this kind of turnaround several months in advance of the actual economic proof. So this is how to not miss the profit train.

For starters, you were most likely investing as if it was a range bound market. So you owned a modestly conservative blend of the best stocks in the best industries. But as the signs of prosperity become clearer, you should shift to a heavier concentration on small-cap growth companies that significantly outperform during the boom times. Again, the Zacks Industry Rank and Zacks Rank for stocks will be excellent guides to get you well situated.

What Do I Think Will Happen?

Which scenario do I believe in right now? And what’s in my portfolio to profit in this environment? I’ll give you a hint. I think the most likely outcome is a combination of the 2nd and 3rd scenario. But I do sleep with one eye open that all those bad loans and government printing press actions come back to haunt us down the road.

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