All long-term investors have the same problem: We don’t like to sell good stocks. That goes double for income investors when it comes to strong companies that have reliably grown their generous dividends.

Happily, not selling is more often than not the right course of action. Last year’s “Flash Crash” and the downturn that preceded it, for example, scared a lot of people, driven as it was by European credit worries and concerns about a global “double dip” recession. But in the end, it all came to naught, and dividend-paying stocks backed by strong companies moved on to new highs.

Similarly, holding on was also the right thing to do during the annual selloffs that seemed to grip the entire income investing universe each spring from 2003 to 2007. Each year, economic growth seemed to pick up, raising fear of higher inflation and rising interest rates. Investors sold high-yield investments for a couple of months, then bought them back as passions cooled and interest rates fell again.

The crash of 2008-09 was of a far greater order of magnitude than these corrections. Frozen credit markets raised fears of another great depression, which fed on themselves to further undermine the global economy and investment markets.

Within a month, the damage done to Canadian income trusts was already several times greater than what followed Finance Minister Jim Flaherty’s Halloween 2006 announcement of 2011 trust taxes. And by March 2009, the S&P/Toronto Stock Exchange Income Trust Index (SPRTCM) was selling for less than half its June 2008 high.

Even this historic collapse–the worst in 80 years–affirmed the doctrine of buying and holding strong companies come what may. Damage was bad, and it took fortitude to hang in there. But so long as companies’ underlying businesses remained solid, their stocks have come back from that debacle. The only real losers were investors who couldn’t take holding on any longer, and therefore sold at sub-optimal prices.

Of course, some stocks did go down for the count. There were bankruptcies and liquidations. Energy producers by and large were particularly hard hit by the decline in oil prices from USD150 to barely USD30. And most natural gas producers and energy services companies are still well off their mid-2008 highs.

Rather than hold on as the market descended into madness, the best course would have been to sell some positions, or at least to lighten up and await the lower prices that were to come. Even Aggressive Holding Vermilion Energy (TSX: VET, OTC: VEMTF), which didn’t cut its dividend during the crash and now trades near an all-time high, fell by more than half from June to December 2008.

Everything inside was rock-solid. But even the most secure energy stocks rise and fall with oil and gas prices. And when things really come down, everything gets caught up in the mayhem.

Ironically, I did pretty much pinpoint the top for Canadian energy producer stocks in the June 2008 Portfolio Update, The Case Against Oil and Gas. My worry was that investors had become excessively optimistic on oil and gas stocks and that a correction was in order.

I did advise selling outright stocks of weaker energy companies such as the former Enterra Energy Trust, which was floundering as a business but was surging in the market along with the rest of the sector. I warned investors not to buy above targets–most were either above them or perilously close. And I pushed investors to take profits in particularly big winners.

That prescription no doubt saved some people some money. Unfortunately, it was far too mild to deal with what turned into a crisis of epic proportion, when only real selling would have kept us high and dry.

In fairness, I don’t know of many if any advisors who were advising an all-out sell on energy stocks with oil pushing above USD150 a barrel. In fact, almost every advisor quoted in mid-2008 was forecasting much higher energy prices to come, and further gains for producers.

But as prices of our favorite Canadian stocks continue to rise across the board, it begs this question: How do we, as income investors focused on long-term wealth building, know when to sell? And, following up, is the current environment such a time to consider such unusual action?

High Anxiety

Afraid to be in stocks, but even more afraid to be out of them: That pretty much sums up the current market mood, in my opinion.

On the one hand are the concerns that make the headlines every day, from the still-shaky state of many banks and governments to the impact of rising commodity prices on the US inflation and the dollar. Unrest in the Middle East has raised new threats to world oil supply, even as earthquake/tsunami damage to Japan’s Fukushima-Daiichi reactors has ignited an emotional global debate about nuclear energy. Finally, the US government seems less able than ever to forge a consensus to deal with fiscal problems.

Each of these is a very real threat to the global economic recovery that began with the stock market bottom in spring 2009. Each has affected the market to some degree, particularly during what was a fairly wild ride in March. But in general investors have shrugged off the news, and stock prices have moved higher.

Those who saw only doom and gloom and impending collapse have instead watched the affected stocks recover and move higher. That’s the same market action that’s repeated itself over and over since the March 2009 bottom. It’s a never-ending reminder to the bears that they’ve missed out on one of the greatest booms in stock market history. And it’s a very big reason why many investors–particularly large institutions that control daily trading–are literally afraid to not be in the market.

Gains in Canadian stocks have, of course, been augmented by a couple of other key factors. Front and center is the Canadian dollar, which has continued to rise against the US dollar this year.

As anyone who has traveled from the US to Canada or vice versa recently can attest, the loony has now moved well past parity. The US dollar now buys only 95.7 Canadian cents, and the exchange rate seems to be relentlessly pushing toward the old high of late 2007, when the US currency bought only 93.3 Canadian cents.

As we’ve pointed out here many times, the loonie is strong for many reasons. For one thing, it’s tended to follow oil prices, which have been in a bull market since early in the last decade. The loonie itself has been in a bull market for a decade as well.

Canadian currency is further buoyed by rising prices and demand for the country’s myriad other commodity exports, which are increasingly being sucked down by Asia’s emerging economies and for which demand is also recovering in the US. That ensures a generally favorable balance of payments, particularly vis a vis the US.

Canada’s financial system proved itself stronger than its counterpart south of the border during the 2008-09 collapse. Canadian banks generally eschewed the subprime lending that got so many US banks into trouble, and they’ve used the improving environment since to further shore up balance sheets and lay the groundwork for future growth.

Finally, the Canadian government–despite being ruled by a Conservative Party minority since early 2006–is far more functional than the US. Despite a ramping up of expenditures to keep the economy whole in 2009-10, the country is on track to achieve fiscal balance in the next couple years. And that’s even while maintaining a comprehensive social safety net (including national health care) and cutting corporate tax rates to 15 percent, which will be by far the lowest in the developed world.

All of this is a stark contrast with the situation in the US, and it augurs further gains for the Canadian dollar going forward versus the greenback. A rising Canadian dollar pushes up the US dollar value of dividends paid by Canadian companies, as well as underlying stock prices. That’s a nice added bonus and it’s boosted US investor returns in Canadian companies by roughly 5 percent this year alone.

Canadian stocks have also gotten a lift from growing investor interest as a haven from inflation, and a play on commodity prices continuing to head higher. And the former income trusts have gotten an extra lift as well, as investors have lost their fear of corporate conversions and institutions have come back to them.

So what can go wrong? A slowdown in the global economy is the most likely catalyst for a retrenchment of all investments related to commodities. Canada weathered the last global economic collapse in large part thanks to demand for its output from emerging Asia. But should those countries–particularly China–seriously pull in their horns, there’s no doubt resource prices will drop, and so will stock prices.

US investors got a double whammy in 2008, as the Canadian stock market and the Canadian dollar fell together. That magnified losses and in fact dealt a dividend cut, as the falling loony depressed the US dollar value of Canadian company dividends. A repeat of 2008 would almost surely deal a similar blow.

There’s also the matter of the upcoming election. As CE Associate Editor David Dittman has pointed out in CE Weekly, the ruling Conservatives are far ahead in polls. In fact, they’re better positioned than ever to capture their first majority, which would keep them in power to 2016. Trust tax notwithstanding, that will lock in pro-investor policies for years to come.

On the other hand, all things political are inherently uncertain. And improbable as it may be, the possibility of a coalition government of the other parties–Liberals, Bloc Quebecois and New Democrats–will hang over the market until the votes are finally counted.

Even an inherently unwieldy coalition government is unlikely to pull the plug entirely on the policies that have kept Canada healthy: support for the energy sector, particularly oil sands development, low taxes, etc. But a cut in the corporate tax rate to 15 percent would be a lot less likely and we could see some energy projects come under attack for environmental reasons. Liberal Party Leader Michael Ignatieff has already come out against a proposed liquefied natural gas export facility in British Columbia, for example.

In my view, however, the biggest danger for Canadian stocks this year is missed expectations. Higher stock prices basically mean investors are projecting better and better things for companies. Those that fail to match up for whatever reason can be subject to wild selloffs–and we’ve already seen that happen to many strong companies.

These single-stock crashes can be triggered by myriad causes. It’s not so much the initial selling that’s important, catalysts for which can range from brokerage downgrades to minor disappointment on earnings/guidance or even nothing apparent at all. Rather, it’s what happens afterward.

Are there stops in place that will be triggered if certain price levels are breached? How many investors have leveraged positions that they’ll be forced to cash out of if prices fall too far? And what happens if all of these mandatory sells come on the market at once? Is ordinary trading enough to absorb them, or will prices go into free fall until all the orders are filled?

A flood of sells with a corresponding dearth of bids: That pretty much explains the multiple 10 percent down days we saw even very strong companies’ stocks make in October 2008. And the more fearful investors get, the more they employ the so-called risk avoidance techniques like stop/losses that can turn a trickle of selling into a devastating avalanche.

This then is a picture of the market for Canadian stocks today: Prices and the investor expectations they reflect are at levels not seen since prior to the trust tax announcement Halloween night 2006, if ever.

The current economic picture is bullish, with the country’s products in demand and the Canadian dollar strong. And the near-majority Conservative Party’s policies are a powerfully positive contrast to what’s happening in most of the world, including the increasingly and pointlessly polarized US.

On the other hand, high expectations mean great possibility of disappointment. A misstep for the global economy can greatly darken the bullish outlook for Canada’s resource exports and, by extension, its overall economy and the Canadian dollar. And that misstep can be caused by myriad factors outside the country’s control, from a new European debt crisis to over-heating oil prices and even a US political/budget blow-up.

The good news is none of these problems appear to be close to the magnitude of what shut down the global economy and markets in 2008, at least at this point. Federal Reserve Chairman Ben Bernanke’s easing moves the past couple years–complemented by central bankers around the world–certainly haven’t pleased everyone.

But they did launch the global economy in a fundamentally different direction than that taken in the aftermath of the 1929 market/credit crash, the last great deflationary event of similar magnitude. Commodity prices that time around, for example, didn’t start to recover until 1935. This time around, the recovery started in early 2009, just months after the crash hit.

To be sure, there’s still a great deal of weakness, and the US isn’t the worst of it by far. Spain, for example, is still dealing with 20 percent plus unemployment. Portugal is in near default, and several other European countries are perilously close.

But it’s undeniable that the recovery has come far faster this time around and monetary easing has been the primary trigger. In fact, the current worries about inflation are testament that the global economy has indeed avoided the fate of the 1930s world.

If you want to worry about something big, you never look where everyone else is. Right now, inflation and bulging government deficits are increasingly getting the attention, so much so that many are proposing radical solutions to deal with them even with the global economy still weak.

That brings me to my greatest macro fear here in early 2011: overly aggressive action by governments to deal with inflation and budget deficits that undermines the global economic recovery before the financial system is fully healed. That is, in effect, what happened in 1937, when deficit hawks forced huge and sudden cutbacks in government stimulus and sent the economy and markets careening off the cliff–from which sprang the political turmoil that triggered World War II.

Should this appear to be coming to pass, it would be time to get a lot more aggressive selling. Happily, that still looks very unlikely. In any case, our Canadian Edge recommendations are better prepared for an economic relapse and/or new credit debacle than they were for 2008, which they weathered. Most have used the past couple years to slash debt, eliminate refinancing risk and focus on running efficient operations.

As such, they’ve laid the foundations for future dividend growth and bullet-proofed themselves against further turmoil.

The question is, are there macro forces at work and expectations so high that we should protect ourselves further? Or should we continue to bet on good companies to keep building wealth and paying us generous dividends?

Tactics and Strategy

Here’s what I advise.

First, it’s still all about business quality. At this point in the markets, we have worries and concerns, not an all-out hot war to react to. That means there’s still plenty of time to strengthen our borders–that is to ensure that all of our holdings have strong underlying businesses.

Portfolio Update reviews every Canadian Edge Portfolio recommendation on the basis of its strengths and upside catalysts for 2011 and beyond, as well as its weaknesses. I’ve also shown where to find my most recent earnings analysis. And don’t forget we’ll be getting a whole slew of first quarter 2011 numbers and guidance starting at the end of this month.

Second, it’s time to do some regular portfolio maintenance that will reduce your risk to a single holding melting down during any potential future crisis. It wasn’t the broad market action that created the permanent holes in portfolios in 2008, or 1929 for that matter.

Rather, it was the shaky stocks that were carried up by the broad market rally as investors bought everything in site, and then crashed as worsening conditions exposed their weaknesses. For a start, get rid of the sell-rated How They Rate stocks. Should conditions worsen appreciably, I’ll be adding to their ranks in coming months. But even with things relatively benign, there are problems there.

You also need to pare back any positions that have grown too large in your portfolio. Exact percentages aren’t necessary. But the more balanced you are, the less likely it is a setback at a single company can take your whole portfolio down. And chances are paring back will also reduce your holdings of the stocks that have run up the most the past couple years, and are therefore most vulnerable to single-stock crashes.

Third, whatever you own, don’t leverage positions and don’t use stop-losses to “protect” positions. That goes double for “trailing stops,” which follow a stock’s price higher. Rather, let’s use evidence of underlying business weakness as our cue to sell. We won’t catch the top, odds are. But we’ll see the slippage in the numbers and missed guidance long before real damage is done.

Finally, selloffs aren’t entirely bad events. They can provide a golden opportunity to pick up good stocks cheap. My best call in the 2008 debacle was adding Bird Construction (TSX: BDT, OTC: BIRDF) in December at the very depths of the selloff. It’s now selling for several times its lows and has raised its dividend 36.5 percent as well. And it was far from the biggest winner coming off the lows.

In Portfolio Update I’ve highlighted a strategy for taking advantage of sudden downward spikes in prices of recommended stocks, using buy limit orders to lock in “dream” buy prices. As I’m not expecting a full-blown crisis, I fully don’t expect the majority of the suggested prices to be reached. And those who want to buy something now are far better off doing so based on my regular buy targets.

Dream buy prices, however, are specifically for taking advantage of market extremes, which by definition are difficult to impossible to predict. They won’t execute unless those extremes are reached. But if they are, you really will be buying high-quality stocks at a bottom, or else very close to it. And there’s no more proven road to riches in the stock market, no matter what’s going on in the world.