Expect the bull, prepare for the bear

NEW YORK (Money) -- Last week's unexpected drop in stock prices has unsettled a lot of investors and restarted serious talk that a recession or a bear market is on the way. Either of those threats could come to pass, of course, but neither is particularly likely.

Still, it's worthwhile to evaluate the real risks of a slump in the economy or the stock market. And it's essential to do whatever you can to protect your investment portfolio.

Let's get the bad news out of the way first. The average bull market lasts for less than three years, and this one passed that mark 18 months ago.

The housing market is deteriorating. And over much of the past three years, inflation has been rising and the Federal Reserve has raised short-term interest rates by more than four percentage points to forestall this.

Finally, globalization and the increasing importance of China, in particular, has left the U.S. stock market far more exposed to what happens overseas. The recent selloff on Wall Street was triggered by a nearly 9 percent drop in Shanghai.

Now, here's the good news. The problems I've just mentioned cause stock price volatility, but they don't inevitably cause a recession - or a bear market. And there are good reasons not to expect one now.

Although the bull market has lasted longer than usual, blue chips are still almost 10 percent below their previous highs. And since most bull markets go on to set new records above the previous peaks, this one should have considerably further to go before stocks are overvalued.

The economy remains robust. Fourth-quarter GDP growth may have been revised down, but earnings for the typical big stock are up around 14 percent, compared with a year ago.

Consumer spending continues to rise at a healthy rate. So do wages and salaries. Overall, the economy will likely to grow at a decent rate this year.

Inflation has actually come down in the most recent months. Consumer prices are now only 2.1 percent higher than a year ago. And if you eliminate certain distortions in the Consumer Price Index that occur when real estate prices fluctuate sharply, annual inflation is less than 2 percent.

Solid earnings growth, declining inflation and low share prices are the characteristics of a good stock market, not of an imminent slump.

Nonetheless, former Federal Reserve chairman Alan Greenspan has said that a recession late this year can't be ruled out, although most forecasters expect continued growth.

With all these cross-currents, it's entirely possible that stock prices will be choppy for much of this year. But looking out to the longer term, the market's prospects seem clearer and a lot more encouraging.

First of all, stocks are reasonably valued today, and some sectors are actually undervalued. That should allow for ample returns as the economy grows.

Second, share prices reflect the balance between the amount of stock in the market and the cash available to buy it, which is called liquidity.

U.S. companies have bought back more than a $1 trillion of stock over the past four years, partly to boost their earnings and partly because they think their shares are cheap.

At the same time, liquidity has increased, thanks to low interest rates and the ability of consumers to borrow against their home equity.

With more hot money chasing fewer shares, shouldn't stock prices get bid up, especially now that real estate looks less attractive as an alternative to equities?

Probably yes. But it's also possible that something could cause that liquidity to dry up. Banks could tighten lending requirements after subprime borrowers default, or a recession in China could force that country to sell off lots of U.S. Treasury bonds.

The point is, no one can know for certain what will happen next. Odds are, stocks will snap back from the recent setback and advance even more energetically to a new high.

But the market will be more volatile over the balance of the year, and there is a chance - one in five, say - that we could suffer a real bear market.

In fact, such risks usually exist in investing, and no forecast can prepare you for the unexpected downturn. Fortunately, there are ways that you can protect your portfolio.

First, focus on the highest-quality stocks and bonds. In theory, lower-grade securities offer slightly higher risk-adjusted returns. But in practice, it's safer for individual investors to go first class.

Second, diversify as broadly as possible. Buy stocks in many different sectors -- at least eight industries if you can. Buy mostly big growth stocks, but include some value stocks and some shares with yields above 3 percent. Buy a few smaller companies if they are high-quality. Put a little money into an international stock fund.

Keep 15 percent of your money in high-quality bonds and also keep a cash reserve, so that you can scoop up unexpected bargains when they occur.

Finally, play for the long term. The shorter your time frame, the less reliable any forecasts will be. Keep a list of good-quality stocks you'd like to own and accumulate them when they dip below your buy price. Over a decade or longer, a diverse portfolio of such stocks should match or exceed the averages.

Whether a strong new market advance begins later this year, as I expect, or the market really does run into some trouble, there will be undervalued stocks to buy in the next few months that will pay off well over the coming years.

And if you can stick with a focused long-term investing strategy and make sure your portfolio is as well-protected as possible, you'll be able to regard any price declines not as setbacks but as genuine buying opportunities.

________________

Recently in Sivy on Stocks:

Home Depot and Lowe's: Renovation under way

Omnicom (Charts): Advertising plays

4 blue-chip values

T. Rowe Price: Bull market winner

Alcoa (Charts): Inflation protection

Bank of America (Charts): Growth, income - and safety, too

Pfizer (Charts): Investing after Pfizer's flop - 3 strategies

Sivy 70: America's best stocks