Monday, May 31, 2010

Defense May Be the Best Offense in the Financial Markets

Individual investors largely sat out the most recent bull market, and the wisdom of the crowd seems to have been vindicated. The Euro zone is the latest debt-fueled asset bubble to pop. The 16 nations that use the Euro are being forced by skittish creditors to deleverage. Since the European Central Bank won't deliberately weaken the Euro (and may be quietly supporting it through sovereign debt purchases in the secondary market), Euro bloc governments have to cut spending. Some may even have to restructure their debt (although none will admit to that). The U.K., with Europe's largest economy outside the Euro bloc, is also retrenching.

In Asia, China is trying to rein in overheated asset markets. North Korea's bellicosity frightens cash into bank accounts. The war in Afghanistan grinds on, with no clear end in sight. Although Asia's emerging economies (i.e., excluding stagnant Japan) are in growth mode, they are too small a bunch of ponies to pull the huge, lumbering wagon that is the combination of the European and North American economies. (China, India, South Korea and the other emerging economies in Asia combined barely total a quarter of Europe and the U.S. together.)

More Sisyphean than the Afghanistan war is the British Petroleum oil spill in the Gulf of Mexico. Nothing has stopped the outflow. Even though yet another temporary fix is being attempted, there is apparently no hope of a permanent solution until August. The amount spilled is in dispute, but there's no doubt it's a lot. Oil is not only spreading throughout the Gulf states, but may come up the East Coast of the U.S. in the Gulf stream. At some point, the spill will discernibly slow U.S. economic growth, and that point could be close.

That said, the U.S. economy keeps growing, at a moderate rate that has pretty much been imputed in stock market valuations. More moderately good news won't revive the bull. There's no indication of a large economic stimulus in the future. With the recession over from a statistical standpoint, and populism surging from sea to shining sea, there isn't enough political support for another spendapalooza by the U.S. government. The Fed can't lower interest rates below the zero level where they now are, and may have to soon begin selling off some of the trillions of dollars of mortgage-backed assets it reluctantly holds.

All in all, this may be a good time for investors to play defense. Be cautious about putting new cash into the market. Ease back on equity exposure if you're losing sleep over downside risk. Since stocks are no higher than they were in 1999 (or 1997 if you consider inflation), there isn't a strong argument that you need always need a large proportion of your portfolio in stocks.

Cash has a beauty that becomes luminescent in uncertain times. Fraidy cats who kept their money in passbook savings during the last decade proved more perspicacious than most professional money managers and most stock market investors. Intelligent and rational people can look at the stock market and reasonably opine it's a looney bin.

That's not to say that stocks need be shunned like a carrier of typhoid. Defense can serve as the foundation for offense. Build up cash and keep it ready for use. If stock values fall to attractive levels, consider buying. Don't think you can time the market perfectly. But with a lot of conventional investment wisdom upended by the volatility of today's big bank, big investor centric market (i.e., the market being of big money, by big money and for big money), it's hard to contend that market timing should be counted as a cardinal sin.

Like all else, however, sin in moderation. Invest only a small proportion of your available cash at a time. Think in terms of cost averaging, not hitting a home run. If the market continues to look attractive, infuse more cash bit by bit. Don't get discouraged if the market declines again. Use the further decline as an opportunity to feed a little more cash into the market. Unless civilization ends (and the combined military strength of North Korea, Iran, al Queda and the Taliban can't end civilization; the recklessness and greed of bankers presents a greater risk), your investments will become profitable eventually.

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