3 Smart Ways to Lower Market Risk

You can’t even begin to measure all the risk in global equities markets now. But you can reduce your exposure. The stocks that fit into these 3 themes should rise even if the global economy stalls.

The past month has reordered global risk and reward.

It’s not just that the S&P 500 fell 17.8% from its July 21 intraday high to the August 9 intraday low. Or that the German index, the DAX, is down nearly 25% in the past two months. Or that emerging markets such as Brazil and Shanghai spent time in actual bear-market territory.

But we’ve also seen Eurozone leaders unable to put an end to the euro debt crisis. We’ve seen the Standard & Poor’s credit rating of the United States go from AAA to AA+. (Fitch Ratings reaffirmed the US as AAA, again, on August 16.)

Japan has slipped back into recession. Inflation has topped official targets, and has been stubbornly resistant to central bank policies. Economic growth has slowed or threatened to slow in most of the world.

Trends that investors depended upon to value stocks—or to tell them where and when to chase momentum—are broken, damaged, or threatened.

Stocks are cheap in most of the world’s stock markets—if past trends reassert themselves after a short interruption. If the trends are truly broken, however, who knows?

What’s a Google (GOOG), or a Vale (VALE), or a Baidu (BIDU) worth if domestic and global rates of economic growth are about to drop by a percentage point or two—or more?

What’s Normal Now?
You have the option of stubbornly insisting that things are headed back to normal. Or that growth and stock prices will revert to the mean. But that begs the question of what normal is and where the mean might be.

Unless you’re willing to throw out the data on economic growth and performance of individual asset classes from the past decade (or more, I’d argue), it’s hard to come up with a long-term trend that can be convincingly projected a decade into the future.

And even then, your trend line would still have to come to terms with changes in global demographics and the global economy that, to me, indicate that the next decade will indeed be different.

To the degree I can, I prefer not to make investing a matter of faith or a gamble on alternatives with unknowable odds.

“To the degree I can” isn’t a very large measure right now. For example, I think the most likely range of US economic growth is somewhere between 1% and 2.5% for 2011 and 2012.

Doesn’t sound like much of a range? Just 1.5 percentage points? Certainly, but the swing is 150% from the minimum and 60% from the maximum.

And, of course, there’s no guarantee that the actual outcome will fall within that “most likely” range. (We've got some recent experience with results that fall into the narrow tail of improbable outcomes, but that nevertheless turned out to be very real.)

Global Economies Are More Unpredictable

Global Economies Are More Unpredictable
And the United States is by no means the hardest economy to handicap right now.

Brazil is inflating its own credit bubble, the government’s will to restrain wage increases is questionable, and inflation is not under control.

In the Eurozone, the European Central Bank has seriously damaged its credibility, leaving the restoration of confidence to political leaders who won’t lead and a European Financial Stability Facility that isn’t yet ready to go into operation.

Indian politics make US politics look like a model of rational discourse. And while the Reserve Bank of India may be the last adult in the room, any parent will tell you that batting the children around doesn’t usually produce good behavior.

I could go on. But I think you get the point.

3 Themes for Reduced Risk
I don’t think there’s a magic method for bringing reasonable certainty to our projections about the global economy and about most national economies. We’re stuck with the fact that these are uncertain times.

The result of that, unfortunately, is that it’s very hard to tell in most parts of the financial markets—and especially in the global equity markets—what the risk might be. You can calculate the reward, but not the risk. That’s the investing equivalent of dividing by zero.

Yet I do think there are three parts of the global equity markets where the risk/reward proposition more than just calculable, it’s actually in the investor's favor at the moment:

1) Dividend-Paying Stocks
If the global economy continues to slow, global interest rates will head down, and that will make dividend yields worth more.

The value in a 3.5%—or better—dividend yield on a stock such as DuPont (DD) or Abbott Laboratories (ABT), when the ten-year Treasury is hovering near 2.1%, should be clear to most investors.

The proposition becomes even more attractive when the dividend is paid in a strong currency such as those of Norway, Sweden, Switzerland, Australia, or Canada.

Take a look at the 5.1% yield from Norway’s Statoil (STO, STL.NO in Oslo). Australia’s Westpac Banking (WBK, WBC.AU in Sydney) pays even more, 7.5%. For more on this, see my recent column “How to pick stocks in an ugly market.”

I can think of two kinds of downside risk with this strategy:

• First, the individual company may not be able to keep up the dividend stream. I think you can minimize this risk by buying shares with strong cash flows behind them.
• Second, the global economy might do better than expected, leading to higher interest rates and higher inflation, which would reduce the value of the dividends.

That is why you’re also looking to buy strong businesses. Shares of these stocks should go up if the economy grows more quickly than is now anticipated.

NEXT: Two More Ways to Lower Market Risk

2) Domestically Oriented Chinese Companies
I’m not sure I’d go so far as to say that China is enjoying the global economic slowdown. After all, Chinese exporters are seeing sales fall. But when everything is added up, the Chinese economy—especially the Chinese domestic economy—comes out on the plus side.

A slowing global economy probably means an end fairly soon to China’s interest-rate increases. The consensus—which can be wrong—is that the People’s Bank won’t risk China’s economic growth during a global slowdown by raising interest rates more than once more. An end of rate increases would remove a big weight from stock prices.

The government in Beijing seems to be picking up the inflation-fighting slack by allowing the yuan to appreciate slightly more quickly. That has the effect of reducing the growth of the country’s money supply and of increasing the buying power of Chinese consumers.

I think adding to positions in domestically oriented Chinese companies such as Baidu and Tencent Holdings (TCEHY or 700.HK), or in overseas companies that sell to Chinese consumers such as Yum Brands (YUM), Sands China (SCHYY) and Coach (COH), would be a good way to play China’s relative growth advantage.

3) US Exporters, Especially Those That Sell to China
A stronger yuan—and a weaker dollar—make US products cheaper for foreign customers. I think this will help US companies pick up some market share, which should be more than enough to offset any slowing in an economy such as China’s.

That is exactly what Cummins (CMI) said in a recent conference call. The company talked about a temporary slowdown in China sales, but a gain in market share over a slightly longer time frame.

In addition to Cummins, I’d also look to shares of Johnson Controls (JCI), Joy Global (JOYG), BorgWarner (BWA), and Timken (TKR).

There are no guarantees that these stocks will go up. If there’s a global sell-off, they’ll go down with everything else.

But if the global economy just stumbles along, these shares should beat the market indexes. And, in my opinion, the risk/reward ratio comes out on the right side of the wager.

Full disclosure: I don't own or control shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Baidu, Coach, Cummins, DuPont, Johnson Controls, Joy Global, Statoil, Tencent Holdings, Timken, and Westpac Banking as of the end of June. For a full list of the stocks in the fund as of the end of June, see the fund’s portfolio here.