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Why stocks are your best bet ... even if recovery fizzles

The most important decision you can make as an investor right now is to figure out where you think interest rates are headed. If you believe an economic recovery is truly under way, you have to think rates are heading higher and invest accordingly. If you think the green shoots are an illusion, you'll react differently.

I don't think interest rates are going anywhere. Low rates will be with us for some time.

According to the headlines, the U.S. economy is supposed to be picking up, Europe isn't as bad as feared and emerging markets are slowing down but still growing.

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Unfortunately, there's a brutal gang of facts lurking in ambush for anyone who takes that optimistic picture at face value.

Take U.S. unemployment. Statistically, it's improving: The jobless rate is down to about 8 per cent from 10. But, according to William Dudley, the president of the Federal Reserve Bank of New York, half the improvement since September comes from a decline in the labour-force participation rate. Simply put, if millions of workers hadn't just given up looking for work, the unemployment rate would be above 10 per cent.

The housing market has also shown supposed signs of life, but much of the activity is in multifamily units – especially smaller apartment buildings. People are renting but not buying, which isn't surprising given the lack of jobs across the United States and the pathetic gains in income.

As the Globe and Mail reported this week, the Economic Cycle Research Institute, which has a good, if brief, track record of predicting recessions (it's three for three), says the U.S. is heading for another downturn.

Meanwhile, Europe must be a train wreck – that is, unless you believe the Organization for Economic Co-operation and Development is in the habit of suggesting $1.3-trillion firewalls for thriving economies.

And then there are demographic trends, which are insidiously working against just about every developed country over the longer term, including Canada.

If you find it too daunting to draw your own conclusion on rates, just look at what the central bankers say and do. Mr. Dudley, of the New York Fed, also sits on the Federal Open Markets Committee, which sets U.S. interest rates. If Ben Bernanke has his way – and he will – rates there are staying low for at least another 20 months. The Bank of Canada is hinting at higher rates, but does Mark Carney really mean it or is it just an attempt to get Canadians to rein in their debts?

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While it's true that government bond yields have risen a little recently, they're still very low – too low for most aging savers – and unlikely to rise.

So what alternatives are left for your money? The stock market. Yes, it seems like a contradiction to recommend equities when the economy is slowing. But it isn't.

You don't want to buy stocks willy-nilly; and you certainly don't want to throw money at a broad market index. It's full of big, liquid, well-known, well-covered, economically sensitive and usually expensive shares.

But the market is also full of little known or underappreciated stocks that can give you an outsized return even in a weak economy. And they're not always riskier.

Three categories are especially appealing.

The first is smaller dividend stocks. There are plenty of stable, small firms paying attractive and modestly growing dividend yields. In a year, investors will be willing to accept lower yields from these companies, as people search for ways to replace their maturing GICs and bonds.

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Look at Alaris Royalty Corp. , which is part of my newsletter's yield portfolio. It's up more than 50 per cent in a year. (Full disclosure: I own shares). The return here comes from a well-managed firm but also investors bidding up the price as they search for yield.

A second category is broken stocks on the mend. Regular readers will recall that I touted Intertape Polymer in this space about nine months ago. It's doubled since because the company overhauled its business and benefited from higher selling prices, even though its volumes didn't go up.

The third category is growth. Over all, consumer demand may be slow but there are specific areas – think WiFi and wireless, for instance – that are attracting a lot of money. Think of all those bandwidth-hungry iPhones and iPads and how they're jamming up network infrastructure. There are big opportunities for companies that can solve the problem.

A weakening economy is never fun, but you shouldn't necessarily run to the safety of fixed income. That could be more risky than stocks.

Fabrice Taylor, CFA, publishes the President's Club investment letter. His letter and The Globe and Mail have a distribution agreement.

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Investment Columnist

Fabrice Taylor, CFA, publishes the President’s Club investment letter, for which he and The Globe and Mail have a distribution agreement. More

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