The Bottom May Be Falling Out -- Here's What To Do

By: David Sterman of Street Authority

Just a few months ago, all was quiet on the investing front, as most market indices continually broke new all-time highs. But in early August, the quiet was broken by a sudden surge by the dollar against the euro, the yen, Australian dollar and other currencies. At the time, the rallying dollar was merely seen as the beneficiary of a relatively robust U.S. economic growth rate in 2015, at least compared to Europe and Japan.

In hindsight, the currency shifts now appear to be the result of something more concerning: European economic activity has slowed to a crawl, the Chinese government is leaning towards a policy of reform over stimulus -- compounded by brewing political troubles in Hong Kong -- and U.S. investors are finally waking up to the reality that global economic growth will likely be subpar in 2015.

That dim view may also explain why West Texas Intermediate Crude Oil has now slipped below $90 a barrel for the first time in 17 months. Then again, oil prices may be slumping because the dollar is rallying, which always hurts the price of commodities such as oil. Or perhaps it's the fact that too much oil is being produced at a time when global demand is slackening.

In other words, there are now a number of moving parts in play, and the factors behind these recent shifts are likely to persist. How you position your portfolio for the changing market can spell the difference between capital preservation and capital erosion.

Indeed many portfolios are already feeling the pain. Small caps are now in a correction, and despite a boost from Friday's jobs reports, larger stocks have started to move off of their highs: the Dow Jones Industrial Average and the SP Jones have both breached support at 17,000, and 2,000, respectively.

The key question, how will the markets play out from here? Well, let's start with the dollar. We know that the U.S. Federal Reserve will end its bond buying program later this month, even as the European Central Bank and the Bank of Japan appear poised to stimulate their own economies. Foreign currency strategists think the divergent interest rate policies over the next few quarters could lead to a further 10% rally in the dollar. And that's bad news for oil, gold or any other commodities priced in dollars -- a stronger dollar erodes the buying power for people holding other currencies.

As a result, it's time to re-check your portfolio's direct and indirect exposure to commodities. For example, oil services companies such as Schlumberger Limited (NYSE: SLB) might see a sharp drop in demand if oil drifts towards $80 per barrel. At that price, many global energy drilling projects become less feasible, crimping demand for oil services equipment such as drilling rigs.

More broadly, investors need to know how each stock in their portfolio is valued. If the major indexes start to move lower, investors will quickly shed their stakes in the market's highflyers. These were the first to crumble in 2008 when investors fled to the safety of value stocks.

This is a good time to prioritize your holdings in terms of their relative valuations. Any stocks that sport high valuations should be candidates for portfolio pruning. If history is any guide, you'll be able to re-acquire these stocks at lower prices when the market finds its footing.

But when will the market find its footing? Understand that the market is driven by herd dynamics. Investors often sell because they fear that mass psychology will lead others to sell. And right now, investors are getting anxious. In the weekly survey conducted by the American Association of Individual Investors, 35% of respondents were bullish on October 2, down from 52% in late August. History has shown that this figure needs to fall to 25% for stocks to truly capitulate, which often sets the stage for next market upturn.

The good news: any stocks in your portfolio that generate solid metrics from a price-to-earnings or price-to-free-cash-flow basis, or sport a solid and sustainable dividend yield are likely to fare well in a tough market. That doesn't mean they won't drop in value, but will likely fall at a much lesser rate than more highly-priced stocks.

To be sure, the U.S. economy still appears poised for solid expansion in 2015. At least that was the conventional wisdom until a week or so ago. Since then, we've learned of a pullback in consumer sentiment and also in manufacturing and construction. Is the U.S. economy starting to feel the impacts of various global crises? It's too soon to know, but we'll know more about that as earnings season gets underway next week.

Risks to Consider: As an upside risk, perhaps the U.S. economy will grow as robustly in 2014 as many economists still believe, in which case stocks don't have too much downside. The only reason to fear a growing bear market is if the U.S. economy starts to weaken in coming quarters. As of now, that is an unlikely scenario.

Action to Take -- Net-net, this is a time for caution. It's OK to begin to nibble at beaten down value stocks, many of which reside in the small cap market. But there is no reason to be a hero and buy the current market pullbacks with a lot of financial firepower. The recent market gyrations suggest that more choppiness lay ahead, and it pays to remember that stock markets can go down a lot faster than they go up. I am not anticipating a rapid market plunge, but history has shown that if buyers pull away in the coming days, then a 10% drop from here can play out in 8-10 weeks. Over the course of the current bull market, we've had several such mini-slumps. The good news: When the sellers exhaust themselves, idle cash can be profitably put back to work.

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