Generating solid returns when markets are uniformly bullish is not so hard. But doing it when markets are volatile and profits are dwindling is a much tougher trick. This sort of adversity is dangerous for clients who have short time horizons, but it also presents opportunities for those that aspire to genuine outperformance.

The current market climate is characterized by both increased volatility and uncertainty for the future, causing a fundamental change in the investment environment in recent months. The credit market disruption has sparked a repricing of risk that has essentially led to a revaluing of assets and a tightening of global liquidity.

As a result, many analysts are anticipating a recession in the U.S. and slower global growth generally. This, in turn, is dimming the outlook for corporate profits and equity markets.

As if this gloomier outlook weren’t enough, this general scenario is itself fraught with a great deal of uncertainty. Some economists suggest that the U.S. will see only a mild recession, if it, indeed, suffers one at all. Others are expecting a more severe, prolonged downturn.

In addition, there are analysts who believe the global economy could prove relatively immune to whatever happens in the U.S., while others maintain that this “global decoupling” scenario is pure fantasy — if the U.S. slows down, the rest of the world slows with it.

The latest version of Merrill Lynch & Co. Inc. ’s global fund manager survey, released in mid-February, suggests that institutional investors fear that at the very least, some aspects of the weaker scenarios will prevail. The report says that perceived risk of recession is rising and two-thirds of institutional investors see the possibility of stagflation, an unwelcome combination of high inflation and low growth.

Moody’s Investors Service Inc. has put the probability of global stagflation at just 15%. But if it happens, the consequences would probably be ugly for financial markets, with major equity markets trading down by an estimated 20% from Moody’s central scenario of continued global growth and relatively low inflation.

As a result of these growing economic concerns, investors are becoming increasingly nervous about investment prospects. Institutional investors’ appetite for risk is at an all-time low and pessimism toward corporate profits is at an all-time high, the Merrill Lynch survey found, noting that fund managers are fleeing to cash and “an unprecedented combination of high cash levels and low risk appetite.”

In a recent quarterly investment letter, ABC Funds Ltd. portfolio manager Irwin Michael, of Toronto-based I.A. Michael Investment Counsel Ltd. , observes: “Currently, investment greed and speculation have given way to increasing investor anxiety and hesitation.”

The big question for investors is how to position their portfolios to deal with this newly nervous, uncertain world. While heading to cash is one option, Michael points out that such periods of fear have traditionally provided “excellent financial opportunities for those who are patient and of firm conviction.”

However, remaining patient and sticking to an investment philosophy is easier said than done for many clients. So far, it appears that many of them are joining the herd in fleeing risk and heading for safety. The latest data from the Investment Funds Institute of Canada show that many fund investors are very cautious. In January, $3.1 billion was cashed out of equity funds, following almost $500 million in redemptions this past December.

But there are ways to weather such storms other than taking refuge in cash. It’s in these types of markets that high-quality advisors truly earn their keep and the value of sound advice skyrockets. And even though advisors must tailor their counsel to individual clients and their particular portfolios, there’s a good deal of insight to be gleaned from experienced investment strategists.

A report from Merrill Lynch’s research investment committee proposes four strategies for dealing with the current investment climate, which it describes as “Darwinian.” With profits shrinking, earnings growth becomes increasingly rare and, therefore, ever more valuable to investors, the report says.

“When growth becomes scarce, investment performance is determined by survival of the fittest,” the report explains, adding that the global financial markets are just entering a phase when such Darwinian conditions are likely to prevail.

To deal with this market environment, the Merrill Lynch report suggests utilizing exchange-traded funds and indexing; employing fundamental indexing strategies; opting for large-cap growth names; and seeking domestic demand stories that aren’t tied to U.S. growth prospects.

@page_break@Indexing makes sense in a more Darwinian market environment because, as the number of stocks that are able to outperform the market declines, the likelihood of picking these winners also shrinks, the Merrill Lynch report says.

Although active managers may have had a decent time of it in recent years, when the market was broadly bullish, the report warns: “You should not be surprised if an increasing number of managers start underperforming their benchmarks in the period ahead, and indexing and ETF strategies become increasingly competitive.”

That said, at a time when there are fewer winners within a market, the portfolio manager who can find those winners stands to outperform the merely average active manager by a significant margin.

Yet, picking the fund manager that’s going to be successful in the future is not much easier than picking the stocks that are going to outperform.

Therefore, one alternative, the Merrill Lynch report suggests, is fundamental indexing, which involves buying an index that isn’t weighted by market capitalization, as traditional indices are, but is instead constructed based on certain corporate characteristics, such as earnings, dividends and book value. Adherents of this strategy claim that it can outperform traditional, passive index investing.

The virtue of using ETFs in this market environment is that it discourages much of the short-term behaviour — such as excessive trading or chasing individual stock returns — that destroys value but which inves-tors are nonetheless enticed to do by the prospect of losses in their portfolios. ETFs also provide diversification and allow retail investors access to previously inaccessible asset classes, increasing their ability to hold uncorrelated assets, which is the central goal of diversification.

Indeed, a report from Montreal-based National Bank Financial Ltd. notes that the innovation of the gold bullion ETF has developed into a significant source of portfolio diversification. It reports that physical holdings of gold through ETFs now represent more than the total gold reserves of the European Central Bank.

For investors who doubt the value of indexing and want more active management, the Merrill Lynch report says that large-cap growth strategies are the best way to go: normally, when markets are more selective, growth strategies outperform value.

The exception to this pattern was in the years around the tech bubble, when value strategies outperformed. However, that was an unusual time, because the companies that were seen as growth plays back then were largely speculative tech companies.

Typically, the companies that are able to generate growth when the economy is slumping are higher-quality firms — and that’s what the Merrill Lynch report anticipates this time around.

Additionally, the report favours large-cap stocks over small-caps on the basis that the firms that are likely to perform well when earnings are generally weakening tend to be the more established companies.

This preference for growth over value and large-caps over small-caps in the current market climate is also echoed by strategists at UBS Securities LLC of New York. Indeed, in a recent report, UBS has revived the idea of the “Nifty 50” — a list of 50 names popularized in the 1960s that were viewed as solid, long-term growth stocks.

UBS has compiled a new list of stocks that it believes can weather the current weak economic conditions better than their rivals. UBS screens for large-cap companies that have global exposure, strong product lineups, low operating costs and have financial leverage — reasoning that companies that rate highly in these metrics should be able to grab market share from competitors that are either too exposed to a single hard-hit region or don’t have the financial flexibility to ride out weakening demand quite as well.

“We believe these companies can use a period of slow growth to their advantage by stealing market share from competitors that are more adversely impacted by the economic downturn,” the UBS report says.

Two Canadian companies make the list — Potash Corp. of Saskatchewan Inc. and Suncor Energy Inc. — along with a selection of names from the U.S. and around the world, ranging from software giant Microsoft Corp. and consumer goods firm London-based Diageo PLC to Japanese automaker Toyota Motor Corp.

In addition, UBS’s global equity strategy calls for a defensive allocation by both region and sector. That means overweighting the U.S. and underweighting Europe and Britain on a regional basis. By sector, it calls for overweighting the telecommunications, health care and consumer staples sectors. Underweighted sectors include materials and consumer discretionary stocks.

Here at home, Toronto-based UBS Securities Canada Inc. ’s strategists note in their report that due to the concentrated nature of the Toronto Stock Exchange — in which 75% of the market cap is represented by the financials, energy and materials sectors — the big issue becomes how to allocate assets among those sectors.

With the possibility of a U.S. recession in the cards, UBS Canada’s report ranks financials as the top pick, noting that the sector has consistently outperformed during recessions. It reports that energy prices typically peak early in recessions, and gold prices peak later. (Gold stocks make up about half of the materials group.)

“The net result is that banks have been roughly even or outperformed energy in the last six recessions and only underperformed golds in one,” the UBS Canada report says.

However, this time around, many of the problems leading to a possible recession are located in the financial services sector, which may render such historical precedents irrelevant.

Another historical truism that may be overturned in the months ahead is never to underestimate the power of the American consumer. While U.S. households have almost always managed to prove their doubters wrong, this time it could be different.

For one thing, the weakness in the U.S. economy is centred in the residential housing arena, which is sure to affect spending as people struggle to hold on to their houses and experience negative wealth effects. Moreover, tightening credit conditions will probably crimp the ability of households to maintain their profligate spending habits.

All of this points to the Merrill Lynch report’s fourth strategy for the current market environment: invest in stocks powered by non-U.S. domestic spending. In recent years, companies tied to the fortunes of the American consumer have been consistent winners. But the Merrill Lynch report expects these types of investments to struggle in coming years.

Instead, stocks driven by domestic consumption in markets other than the U.S. could become the winners of the future, the report suggests. Certainly, the fundamental growth prospects appear better in regions other than the U.S., and various economists are expecting stronger domestic demand to bolster economic growth in emerging markets.

Again, picking the likely beneficiaries of this theme is easier said than done, but the rewards for doing so — at a time when the number of market winners is starting to dwindle — are that much greater.

There’s no question that the current market environment is scary and fraught with uncertainty. But these are also the sort of conditions that may allow shrewd, serene investors to generate higher returns. IE