What if 2012 turns out to be another 2008?

That question is on the minds of many investors I talk to these days, particularly as market volatility has increased once again.

The beneficiaries of recent action have been the old safe havens, US Treasury bonds and German bunds, whose yields have plunged to historic lows.

The losers have been almost everything else, as fearful big money has attempted to shed risk as fast as it can–and all too many skittish investors have followed in their wake.

As I pointed out in the April 2012 Feature Article, the case for Canada is still very strong. David Dittman has consistently reinforced that message in the weekly Maple Leaf Memo, which is archived on the Canadian Edge website along with past issues.

Gauges of the economy’s health, such as employment, remain steady. Banks are in the pink of health, demonstrated by robust fiscal 2012 second-quarter earnings. Resource exports are booming, as is resource patch investment. And the country’s government is both politically stable and near fiscal balance.

But Canadian stocks too have taken a hit the past couple months, as investors worry slowing growth in Asia and a recession in Europe will depress global demand for natural resources.

The Canadian dollar didn’t fall as dramatically as oil prices did in May (crude was off 18 percent last month). But it did come down from a value of about USD1.02 to around USD0.97, adding to losses for US investors in Canadian stocks.

This is basically the same action that we saw in 2010 and 2011, when global economic scares temporarily triggered mighty selloffs for stocks across the board. The happy ending to both of those debacles was a torrid late year rally, which propelled the vast majority of Canadian Edge Portfolio Holdings into the black for 2011.

In fact, that surge gave us a third consecutive profitable year for the Portfolio.

My forecast is for something similar this year. We have given back the year’s early gains, with the exception of real outperformers such as TransForce Inc (TSX: TFI, OTC: TFIFF). But with the exception of a couple of energy producers, most CE Portfolio companies are either still in the black or very close to it.

It won’t take much upside to make 2012 a solidly profitable year.

As I point out elsewhere in this issue, very few Portfolio companies–and in fact most companies in the CE How They Rate coverage universe–are leveraged in any meaningful way. Neither is most investment money around the world, as investors prepare for worse ahead.

That’s a stark contrast with the big picture in mid-2008, particularly in Canada’s then-surging energy patch, where expectations were for USD200 oil and more.

Roots of a Crisis

Really catastrophic selloffs are only possible when there’s a combination of truly awful events and enough people leaning in the wrong direction who have to sprint for the exits. Excess leverage and too much risk-taking were what turned a sector crisis in 2008–namely the downturn in US real estate–into the world’s greatest systemic crisis since 1929.

Starting with the implosion of Lehman Brothers, confidence vanished overnight. Every financial institution suddenly became suspect, and with good reason. Credit tightened dramatically, forcing any company that needed to borrow or refinance debt to pay loan-shark rates.

Whole industries, such as mortgage real estate investment trusts, were liquidated. Businesses pulled in their horns on capital spending, stopped hiring and started firing.

When you ask the question, Can there be another 2008?, you’re basically asking whether any of the myriad risks facing the global economy have the potential to become systemic.

Starting with Europe’s credit crunch and economic slide, European stocks have definitely been hit hard. But despite Greece’s near default and severe problems in Spain, the problems have yet to really spread anywhere else in the world, other than on the margins for some companies.

Spain is definitely a much larger and more important borrower than Lehman was. But its problems–as well as those of Greece, Ireland, Portugal and even Italy–are well known. That’s a huge difference from the Lehman situation, which came as a complete shock to most.

Just because a problem is known doesn’t mean it can’t bite someone. But it’s going to affect a lot fewer companies, governments and individuals, simply because people have time to protect themselves.

Moreover, it appears Europe is in fact moderating its recent austerity, which should take at least some of the current economic and political pressure off the euro.

Slower growth in Asia has sent natural resource prices lower, which does hurt Canada. Here too, however, the worst may be behind us, as governments in China, India and elsewhere turn their attention from fighting inflation, which was in large part caused by surging commodity prices, to spurring growth and employment.

Finally, there’s concern about the US election and a potential “fiscal cliff” of tax increases and government spending cuts starting in 2013, unless Washington can cobble together a budget compromise beforehand.

The worry is such a dramatically contractionary fiscal policy change will derail what’s been a jagged but persistent economic recovery in the US since mid-2009.

Politics and economics are always a volatile mix. And the events of last year, when the US government only raised its debt limit at the last minute, have understandably undermined investors’ faith in Washington to do the right thing.

Then again, a compromise was ultimately reached. And Europe’s austerity plans have noticeably failed, as government spending cuts have slowed growth and reduced revenue, widening budget shortfalls.

As a result, it seems unlikely pragmatists like President Obama and his Republican challenger Mitt Romney would risk plunging the country into such potential chaos.

The bottom line is I don’t see a systemic crisis in our future. That means the selling we are likely to see this summer should be viewed as a buying opportunity. Portfolio Update shows how to take advantage.

I will, however, add two very important caveats.

First, I tend to be optimistic as an advisor and an investor. This view has served we well the last 26 years in this business, but it’s also sometimes caused me to underestimate potential downside.

Second, I definitely want to be prepared in case one of these challenges, or something now unforeseen, does wind up creating a systemic crisis.

Fortunately, the crisis of 2008 provides a ready example of what’s likely to happen if there is a real systemic event this year. What got hurt the most then is almost certainly what will get hurt worst now.

And we can minimize the potential damage to our own portfolios from a reprise by making sure we’re in what held up best.

Lessons from the Fall

If you’re invested in dividend-paying stocks, you’re not going to avoid volatility. But you can dodge companies that crack up as businesses during the crisis.

The most important lesson from the 2008 crash was that almost every stock fell. But companies that maintained or increased their dividends eventually recovered, no matter how far they fell during the heat of the crisis.

Here, by sector, isthe number of dividend cuts in the Canadian Edge How They Rate universe from August 2008 through August 2009:

• Oil and Gas–36
• Natural Resources–14
• REITs–9
• Energy Services–6
• Financials–6
• Closed-End Funds–4
• Business Companies–3
• Food and Hospitality–3
• Information Technology–2
• Electric Power–2
• Gas/Propane–2
• Transports–2
• Energy Infrastructure–1
• Health Care–0

There were 36 dividend cuts among the 30 or so oil and gas producers I track, with several forced to reduce more than once. In fact, of the then income trusts, only current CE Aggressive Holdings Crescent Point Energy Corp (TSX: CPG, OTC: CSCTF) and Vermilion Energy Inc (TSX: VET, OTC: VEMTF) did not cut.

Energy producers’ cash flows depend on management’s ability to execute production plans, but also on realized selling prices. When oil and gas prices crash, so does cash flow.

Management can borrow and hope prices rebound, reduce capital spending on production or cut dividends. And 99 percent of the time, the latter is the prudent course to follow.

Thus far in 2012 AvenEx Energy Corp (TSX: AVF, OTC: AVNDF) and the former NAL Energy Corp are the only Oil and Gas Producers tracked in How They Rate that have actually cut dividends. They cut mainly because of sharply lower selling prices for natural gas.

Several other producers are currently on the Dividend Watch List for their gas exposure. But at this point most have protected themselves from low natural gas prices by a combination of conservative financial policies and focusing on oil and natural gas liquids (NGL) production.

The systemic risk is if weakening global demand drives down oil prices a similar amount. That’s what happened in 2008, and the result was a complete rout of the sector.

The only way to fully protect against a repeat is simply to avoid this sector, with the possible exceptions of Crescent Point and Vermilion, as neither cut their dividends in 2008.

In addition, Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF) can earn a 30 percent margin at USD1 per million British thermal unit natural gas, a compelling reason to hold it through thick and thin.

I, however, intend to hold all of the energy producers in the Aggressive Holdings. They are well protected from weak gas and are conservatively managed. And with energy prices still likely to rise in the long haul, there’s also considerable upside from these levels.

Next up in vulnerability to a 2008 reprise, not surprisingly, is the Natural Resources sector, with 14 cuts for the 12 months ending Aug. 1, 2009. Like oil and gas producers, these companies depend hugely on the price of what they sell.

As was the case with oil and gas stocks, virtually all Natural Resource stocks I cover took a hit in 2008. However, neither Ag Growth International (TSX: AFN, OTC: AGGZF) nor Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF) were forced to cut their dividends.

And they’re arguably much stronger companies now than they were then, with conservative financial and operating policies and no maturing debt through the end of 2013.

If they do take further hits, past performance is a pretty good indication they’ll rebound. Acadian Timber Corp (TSX: AND, OTC: ACAZF) did reduce its payout during the crisis as part of its conversion to a corporation. But with no debt maturing, it too looks better prepared to handle a potential debacle.

Real Estate Investment Trusts (REIT) were surprisingly third in crisis dividend cuts. The numbers of cutters, however, didn’t include any of the five in the Conservative Holdings: Artis REIT (TSX: AX-U, OTC: ARESF), Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF). Dundee REIT (TSX: D-U, OTC: DRETF), Northern Property REIT (TSX: NPR-U, OTC: NPRUF) and RioCan REIT (TSX: REI-U, OTC: RIOCF).

Rather, the damage was largely confined to a handful of newly-minted REITs, mostly focused on what were then red-hot areas for property investment.

Lanesborough REIT (TSX: LRT-U, OTC: LRTEF), for example, eliminated its payout in early 2009 after vacancies at its Fort McMurray, Alberta, properties soared in the oil sands patch downturn.

My five picks avoided its fate largely by adhering to conservative financial and operating policies they still keep today. Occupancy rates are almost never less than 95 percent, and no acquisition is made unless it’s immediately accretive to cash flow. Debt is kept at moderate levels, with little exposure to near-term credit markets.

So long as our Canadian REITs hold fast to that strategy, I’ll stick with them come what may, just as I did in 2008. Conversely, I continue to advise avoiding leveraged Canadian and US REITs, which are just as vulnerable now as in 2008.

The Energy Services business is doubly leveraged to energy prices. Demand for rigs, equipment and services rises when drilling activity increases, allowing companies to raise rental rates and fees as more of their capacity is used.

Demand drops when energy prices fall and drilling activity slips, which increases idle capacity and cuts into rental rates and fees.

The result is that Energy Services stocks are very sensitive to oil and gas price swings as well as to expectations about where energy prices are going.

That’s clearly showing up in the underperformance of Aggressive Holding PHX Energy Services Corp (TSX: PHX, OTC: PHXHF), despite a 50 percent dividend increase this year.

I’m OK holding PHX as well as fellow services firm Newalta Corp (TSX: NAL, OTC: NWLTF), despite potential exposure to systemic risk. Both operate growing franchises that have bright futures. But investors should expect volatility, particularly if oil does head much lower.

The Financials that cut dividends in 2008-09 were mainly niche companies such as GMP Capital Inc (TSX: GMP, OTC: GMPXF), which suffered from reduced Toronto Stock Exchange (TSX) activity even as big Canadian banks weathered the storm.

One that did not cut was Conservative Holding Davis + Henderson Income Corp (TSX: DH, OTC: DHIFF), which continues to increase market share providing services to those big banks. I’m comfortable holding it against the possibility of another crisis, in part because of the health of those big bank customers.

As for the rest of How They Rate, the cutters were the over-leveraged exceptions, not the rule. In the Electric Power group, Algonquin Power & Utilities Corp’s (TSX: AQN, OTC: AQUNF) late-2008 reduction was actually part of its conversion to a corporation rather than a sign of business weakness.

None of the pipeline companies in the Energy Infrastructure group were threatened during the crisis. The only cutter in the group was Westshore Terminals Investment Corp (TSX: WTE-U, OTC: WTSHF), whose situation is completely different as coal terminal revenues were still tied to coal prices fetched by the former Fording Canadian Coal. That’s no longer the case today, and dividends are therefore much less exposed.

Pipelines and power company stocks can be volatile. But based on their 2008 performance and our favorites’ strengthening as businesses since, these companies would be about the safest place to hide during a systemic debacle.

Closed-end fund First Asset Pipes & Power Income Fund (TSX: EWP-U, OTC: FAPPF) holds a large number of favored energy infrastructure and power companies. But any of the picks in the Conservative Holdings are excellent buys now.

Other sectors such as Transportation and even Information Technology don’t have quite that level of assurance as basic businesses. That’s why I continue to pay such careful attention to debt, particularly what’s coming due between now and the end of 2013.

And I look at any and all indications of underlying business strength, from payout ratios to revenue growth and profit margins of key operations.

The market constantly teaches us to be humble. And I’ve been rightly accused in the past of being too sanguine about certain companies’ prospects as well as overall market risks.

If one of today’s challenges does morph into a genuine systemic crisis, there will no doubt be casualties even among stocks I’ve carefully picked out. That’s why diversification and portfolio balance are so important, so a single bad pick won’t sink you.

It bears saying, however, that the Canadian Edge Portfolio did weather the crisis of 2008 without a lot of thrashing around. And with a few additions and deletions, it posted great years in 2009, 2010 and 2011.

That’s testament to the value of sticking with stocks of great companies throughout the market’s ups and downs, so long as their underlying businesses remain solid.

And that’s the real secret to weathering whatever knuckleballs the stock market throws at you, including those happily rare meltdowns when absolute disaster strikes.