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A time for caution

Thursday, May 19, 2011


As we cross the mid-point of May 2011, we have seen a very nice market recovery from the lows of 2008-09 when the financial crisis was at its deepest. Where do we go from here? And how can we make money doing it?

Current situation

Most major markets have recovered from depression like collapse. Equities may be reaching danger point if you are buying in now. Bonds are scary because of the interest rate situation (yields have nowhere to go but up, which hurts bond prices). Most of the gains made over the past few years have been in more risky/volatile assets like energy, resources, precious metals and emerging markets.

The U.S. is still bogged down by debt. Government stimulus and record low interest rates haven’t jump-started the economy, and the prognosis isn’t positive. Unemployment is too high, housing hasn’t recovered, and the consumer weakened by poor household balance sheets. How will the economy do on its own without the benefit of government stimulus?

The European situation isn’t clear either, with much sovereign debt due in 2011. Greece, Ireland, Portugal, and Spain are in rough shape. As members of the common currency eurozone, they can’t devalue their currency or lower interest rates to defuse, devalue, or inflate away fiscal problems. Fiscal austerity is ultimately really their only recourse, as Germany and France will not fund bailouts indefinitely.

Emerging markets have large, young populations and growing economies, but there are some concerns about inflation derailing (or slowing down) their continued expansion. They have led the way out of the recession, while the U.S. has stumbled along.

What to do

The reality is that equities might be at or close to highs, bonds are scary, and the real money-making sectors are all risky. That doesn’t leave you with many palatable options for investing new money.

However, you can rebalance portfolios and perhaps take some risk off the table. One solution is to look for dividends, which pay you to wait.

Another is to dollar cost average your purchases over the next year if you have new money to invest. This helps mitigate some of the downside risk. You could also simply keep 20% to 25% in cash in case of a correction.

Make certain your portfolio is well diversified. Equities and various fixed-income instruments are only a start. Do you have some gold, real estate, infrastructure, and emerging markets exposure? Most investors need some exposure to these sectors because most do not correlate closely to overall markets. Emerging markets also give you access to where the lion’s share of world growth will come from in the foreseeable future.

Be very careful about getting into precious metals and energy now, even though I believe the fundamentals for these asset classes are still good. When something goes up so much for five years, you need to be careful getting in late. Now is not the time to be greedy. Get greedy when markets are in crisis and everybody else is selling. Markets (normally) punish greed and reward patience.

Don’t be afraid to keep some cash or money market funds and wait for the next opportunity. Patient investors are usually rewarded. Investors who get in after great gains are historically punished (technology in 1999 was a good example of that principle). This is another reason why I tend to favour holding some real estate funds. You get steady income, and the sector has suffered recently, so you are buying when it is out of favour. Don’t be afraid to be contrarian. History has show that an investor who buys the previous year’s worst sector does better than one who buys the sector that performed best.

Outlook

At present, I am more pessimistic than optimistic, mostly because of the strong recovery, European debt concerns, and multiple problems in the U.S. economic machine. We have done well with emerging market economies leading the way, but if demand slows and a secondary problem arises (another U.S. recession, for example, or the European sovereign debt crisis infecting more countries), then things could get ugly.

 

 

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