Must-Have Stocks for the Next Correction

One thing's certain: Sooner or later, the market will correct.

Less likely, but not improbable, is that the future is already nurturing a second financial crisis, to be triggered by some as-yet-unknown cataclysm.

Whichever one happens, the key question is this: Are you and your portfolio prepared for the market to do something other than just go up?

The right stuff
You might not be bothered at all by the prospect of the market eventually swooning 10%, 15%, or even 30%. You've got cash on the sidelines, and you'll put it to work as stock prices tumble. Then it's just a matter of riding things out.  

There's certainly nothing wrong with that approach. But if you're anything like me, the aftermath of 2008-09 saw you searching for ways to actively reduce portfolio risk, particularly at times like now, when the market's valuation begins to look less than attractive.

In this regard, there are all sorts of things you can do to make money when you think stocks will do badly. Selectively using inverse sector ETFs, options-based strategies like straddles and strangles, or selling short the shares of overvalued and/or fundamentally weak companies all can produce profits when stocks fall. Add to the mix non-stock investments like currency funds and commodity ETNs, and the retail investor can hedge almost as nimbly as the pros.

Sounds great. But while each of those tactics has merit when used intelligently, they can get pretty complicated -- and they have their pitfalls. If you'd rather do something a bit simpler, there's a more familiar approach to protecting against portfolio downside. Technically, it's playing defense more than it is hedging, but the results are nonetheless impressive. It's called -- are you ready? -- stock picking.

Don't believe that could work? Read on.

Seven relative winners
Below, I've highlighted seven stocks that significantly outperformed the market during the two worst periods of the 2008-09 financial crisis: (1) from before the Lehman bankruptcy to the low in late November 2008; and (2) from the failed rally in January 2009 to the ultimate market trough in March.

Data based on author's calculations using historical stock prices from Yahoo! Finance; does not account for dividends.
*Number of percentage points.

I'll admit that some of those numbers don't look very good. But in light of the S&P 500's larger drops -- 39.9% during the first period, and 27.6% in the second -- these stocks held up relatively well.

Of course, the above stocks shouldn't be taken as official recommendations. Furthermore, there's no guarantee that any of them will outperform during the next market dislocation. But I do believe that the odds favor such an outcome -- and that the fundamentals of several of those companies should support future outperformance.

Let's begin with Teva, the one stock to actually appreciate as the market hurtled toward its March capitulation. The world's leader in generic pharmaceuticals, Teva stands to benefit as controlling health-care costs becomes a greater priority for both individuals and governments. Plus, $150 billion in brand-name pharmaceuticals are losing patent protection in the next five years, which creates a structural tailwind for the company.

Granted, there are risks to Teva's rosy prospects. For one, the ongoing consolidation of U.S. retail drugstore chains, hospitals, and other entities means that Teva's customers are gaining purchasing leverage, which is another way of saying that Teva's selling prices are under pressure. Similarly, the move into generics by branded-drug maker Pfizer (NYSE: PFE) is likely to increase pricing headwinds. That said, the company's branded business -- currently at 30% of sales -- should help offset margin erosion in the generics segment. And at a forward P/E of 11.5, shares appear amply discounted.

Two more for the road
For utility Exelon, the only path appears to be upward. The stock is already dirt cheap, but it may not remain so for long. Recently, management reported that improving electricity demand is emerging earlier than expected, thanks to industrial growth. Plus, Exelon shares offer investors backdoor exposure to a stronger natural gas market, as power prices are set according to the cost of marginal -- that is, natural-gas generated -- energy.

Finally, there's ExxonMobil. Its stock has largely missed out on the most recent phase of the market rally, as shares are down roughly 2% since the energy behemoth announced its acquisition of natural gas player XTO Energy (NYSE: XTO) last December. But if the supermajor is right about the long-term growth of natural gas demand, the acquisition will be a smart one -- and buying shares today at a forward P/E of 9.5 is a steal, one that likely comes with limited downside in the event of market mayhem.

Keep your wits about you
In a recent Barron's interview, Andrew Lo, head of MIT's Laboratory for Financial Engineering, had the following to say about supposedly diverse asset classes:

They only become correlated in times of crisis. But that's when it really counts. And that is the key insight into the stock market.

Which is to say that even the keenest stock picking is unlikely to fully protect your portfolio during times of sweeping financial distress. But if you regularly and honestly assess your portfolio's downside potential -- and if you have the guts to remind yourself of the events of 2008-09 every now and again -- then your odds of a smoother ride greatly improve.

Cheers to that.

Want more great stock ideas? Fool contributor Anand Chokkavelu knows seven cheap stocks with proven track records.