A Christmas-Comes-Early Portfolio

The market may seem pretty confusing right now, but trust me, by the time Christmas rolls around, it will all become crystal clear. When you've got a fire warming the hearth and Andy Williams ballads rocking your iPod, you're going to think back on missed opportunities this summer, slap yourself on the forehead and let out a big "D'oh!"

So what is it that will be obvious in hindsight? It's probably a devilish blend of three positive and two negative events. Take your pick, and combine as appropriate:

• Unexpected armed conflict in Lebanon and Israel pushed U.S. stock prices down to levels that discounted way too much pessimism over the potential impact of higher crude oil prices. Shares of American capital goods and industrial manufacturers got too cheap. Should have scaled into them over the summer.
• Seventeen straight interest rate hikes by the Federal Reserve led wary investors to become overly pessimistic on monetary policy. Rising rates have smashed shares of U.S. homebuilding companies to levels previously seen only during recessions. Should have scaled into homebuilders that were priced around book value.
• Reports of rising semiconductor inventories, sinking prices and a lack of buzz on hot new electronic gizmos led investors to punish technology stocks to low valuations. But then it turned out that a hot new Sony(SNE Quote) PlayStation 3, flashy new video iPods and a surprisingly cool, small wireless media player from Microsoft(MSFT Quote) emerged in the fall and sold millions of units. Should have scaled into battered or bruised tech stocks with solid growth prospects and undernourished expectations.
• Three years of a low-volatility bull market lulled investors into a false sense of security. They whistled past all the classic warning signs of a bear market akin to those of 2000 and 1974, expecting the decline that began in May 2006 to reverse by the fall. Yet geopolitical tensions, monetary-policy overkill and a collapse of business and political confidence undercut virtually all sectors of the market except the most "defensive." Should have sold everything but bonds, utilities, drugs and consumer staples over the summer at the start of their multiyear rebound.
• The political collapse of the Bush administration after years of political, military and fiscal missteps led to a sweep by Democrats in the midterm congressional elections. New House committee leaders appear ready to follow through on their threat to launch impeachment hearings against the president. Foreign investors flee U.S. equities over the governmental turmoil, and stocks of all stripes sink to three-year lows.

I grant you, it's a bit puzzling that the latter two scenarios contradict the first three. But when you're forecasting a future review of the past, you need to allow for some ambiguity. And the good news is that as an investor, you can build a portfolio to accommodate all of these potential circumstances by carefully choosing groups of stocks that will succeed in each, and then weighting them by your view of their probability. This way, you're prepared on all fronts and can add to the stocks that are winning as they surpass performance milestones.

Crisis Consulting

Of all the viewpoints, it seems to me that the first is the most likely to turn out to be accurate. Ned Davis Research published a report late last week that reviewed the performance of the market in the one-month to one-year spans following major financial or military crises. On average, the decline of stocks concurrent with the crisis flash point is 5.7%.

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