10 ways to beat a bad market

By Tim Middleton

With inflation accelerating to 5% in July and unemployment rising ominously, stagflation has arrived. This miserable combination of rising prices and slowing economic output was death to equities in the 1970s.

It is damn hard to make money in this environment, but it isn't impossible. If bear markets do any good, they reveal the timber that isn't reduced to ash in a firestorm.

• Video: Will inflation spiral higher?

Some asset classes thrive in prolonged adversity, others simply outperform the market, and still others become so attractively priced they can be stuffed wholesale into your nest egg.

Here are 10 strategies for using the current conflagration to set your returns on fire:

Cover your core

In good times and bad, every portfolio should have an anchor of large-capitalization domestic stock mutual funds.

These are the companies that will survive, and you don't have to worry whether the U.S. dollar is weak or strong. The archetype is Vanguard 500 Index (VFINX), the investable form of the market's benchmark index, though an actively managed fund such as Fidelity Contrafund (FCNTX) is a better choice.

Retirement plans like 401(k)s are the perfect structure for your core portfolio because you make automatic contributions through thick and thin. Make sure you continue to take advantage of this power by directing a significant fraction of your total kitty -- a minimum of 30% -- into big-cap U.S. stock funds. And don't stop saving.

Overweight small-cap stocks

Modern portfolio theory advocates tilting your portfolio toward small caps. They are riskier and therefore may return more over long periods. But their particular appeal at a time like the present is that they have shown themselves uniquely able to prosper under the lash of stagflation.

In the 10 years ending in 1980, the annualized return of U.S. small caps was 17.5%, nearly twice the 8.4% return of the S&P 500 Index ($INX), according to Morningstar. These were years of high stagflation, and the outperformance of small caps was strongest and longest then, and nearly as good in the 1960s. They underperformed in the 1980s and through most of the 1990s, and for the past year they have been dreadful. But their season is back.

Buy nuclear power

Even greens have finally awakened to the fact that nuclear power is the wisest way to generate electricity on a vast scale, as the French have known for decades. Three exchange-traded funds, Market Vectors Nuclear Energy (NLR, news, msgs), iShares S&P Global Nuclear Energy Index (NUCL, news, msgs) and PowerShares Global Nuclear Energy (PKN, news, msgs), own the world's heavyweights, including Exelon (EXC, news, msgs) and Electricite de France (ECIFF, news, msgs).

All three ETFs have short performance records, and none is exactly setting the world's bulbs alight at the moment. But the theme is irresistible. The Market Vectors fund is by far the largest and most liquid of the three and the easiest to trade. Bid/ask spreads will be tightest, which means the transactions costs will be the lowest.

Shun socially responsible investing

If you can embrace nuclear power, you can give your other political prejudices a break as well, and by doing so make a lot more money. Socially responsible investing, or SRI, does OK when everything is hunky-dory, but at the first sign of trouble returns will be harder to find than an honest member of Congress.

Domini Social Equity (DSEFX), one of the largest and oldest SRI funds, has been beaten by 83% of other large-cap core equity funds over the 10 years ending June 30, according to Morningstar, and in the bear market year of 2000 it trailed the S&P 500 by 6 percentage points, or about 40%.

Buy emerging markets

Emerging markets are getting clobbered like everything else at the moment, but over the next decade they will outperform developed markets because they're building on a smaller base. China, the powerhouse among them, has a political imperative to extend prosperity to its hinterland or face extinction, and totalitarians don't go down easily.

The sheer magnitude of China's challenge is mind-bending. The nation is roughly the same size and shape as the United States, yet its prosperity is confined to a few tens of miles along the equivalent of our Atlantic coast. As a history lesson, it stands where the United States did at the end of the 19th century, with all the growth potential that represents.

Buy Treasury inflation-protected securities

Introduced when inflation was tame, TIPS pay a small yield, but their principal is adjusted annually to reflect the rise of the Consumer Price Index.

Continued: Pimco Real Return

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