Investing in the New Economic Paradigm

Image by ocean.flynn via Flickr

I'll continue with the sparse summer posting. It seems these days my time is spent passed out on the couch from overconsumption of otter-pops.

There's little doubt the last two years have changed the rules for investing and managing risk. Constructing your investments based on historical information worked as long as financial markets dealt the same types of risks (though the timing around the manifestations of those risks were completely random). In short, we all learned that when dealing with models, garbage in equals garbage out. Yes, models are helpful and they help crystallize your thinking, but it should not be a substitute for a good deal of independent critical thinking. So with all the uncertainty surrounding where the market is headed over the next 1,3,5, or 10 years I thought I would share a couple of thoughts. Perhaps they will be of some benefit (but probably not).

1) The current recovery may be little more than a "Dead Cat Bounce". Perception is reality. Based solely on the number of editorials, articles, and reports I've seen over the last few weeks, I conclude the majority of US citizens assume the worst is behind us. Which is extremely curious. Based on fundamental information only, there is no justification of a recovery. In fact, less than 15% of all the stimulus has been deployed. Although this is curious, its not surprising. In a previous post I noted Mordecai Kurtz's (Stanford) research on behavioral economics. Kurtz concludes fully four-fifths (80%)of the movement of a stock price is based on behavioral factors, not technical. Markets move up when the majority of investors hold optimistic expectations of the economy and down when the collective view is pessimistic. To me, this conclusion means the American psyche could be in for a huge disappointment. Banks and Insurance companies still have a tremendous amount of exposure to commercial mortgage backed securities, which, by the way, have yet to correct for pricing. If this happens, unemployment could easily reach 15% which, I imagine, will have a devastating affect on investors who assumed the worst was behind us.

2) If traditional asset allocation, modern portfolio theory doesn't work, what does? Perhaps a prudent way to evaluate investments is with three scenarios in mind; growth, depression, inflation. This allows one to be less rigid in their approach and forces investors to consider the macro environment before making a decision, instead of blindly following an allocation model. How much you allocate to each is based on your personal macroeconomic perspective. True diversification is a moving target. Writing in broad generalities, in the growth bucket you would target public stock, high-yield bonds, Real Estate, and avoid T-bills and some commodities. In the Depression bucket you would focus on holding T-bills, Gold, Foreign Reserve Currencies, and short duration government bonds but avoid exposure in US stocks or high-yield bonds. Inflation warrants investment in Commodities, Infrastructure (like toll roads, power, hospitals, etc.)and international markets. You might allocate a third of your resources to each bucket (growth, depression, and inflation) and tilt the allocation one way or the other based on your outlook. One note, exercise prudence when purchasing or selling securities to avoid buying at the height of the market. You could either dollar-cost average (purchase $200 of XYZ security every month/week/etc.) or use some light market timing. An example of "light" market timing would be waiting to buy gold. Gold is trading at historically high levels. Rather than wait for it to return to "normal prices", which may not happen for a few years, you would wait for it to come down, say 10%, and then make your purchase. In other words, you're simply being more opportunistic when you make your purchases. Unless you have a good understanding of a sector, its probably best to dollar-cost average.

Anyway, I'm not providing specific advice, nor am I providing any advice for a fee (now you can't sue me). Rather, I'm simply introducing a couple of ideas that readers might find helpful and would like to study in more detail (on their own).