One of the hallmarks of a smoothly functioning ec0nomy is the efficient flow of capital to the most attractive opportunities. These can exist in stocks, bonds or direct investments. At other times nothing seems very attractive, either because it’s too risky or too pricey. That’s pretty much where we are today and it’s the mark of an economy that is not functioning smoothly, which is hardly a surprise since we are still emerging from crisis intervention in the capital markets by governments around the world. It’s hard to overstate the effect that intervention had on the price of assets far and wide. Now the U.S. Government is pulling back as the sugar daddy of capital markets–so too are many other governments– but stocks and corporate bonds are now far more pricey than they were before the feds became involved. Sure, there’s talk of a second stimulus, but nothing will happen before election season is well past. That leaves investors large and small in a frustrating fog. But even in a fog there’s a right way and a wrong way to proceed.
First, it’s important to know what the big players are doing. A report from BofA Merrill Lynch on hedge fund activity points to a herd that is pulling in its horns. In the second quarter, for example, hedge funds reduced their net exposure to stocks for the first time since early 2009. Further, Merrill notes, its study of 817 hedge funds shows cash levels rising and leverage falling–sure signs that the pros think the government-financed rally is pretty much over. True, this data is a couple of months old and hedge fund managers may have turned into snorting bulls over the late summer, but don’t bet on it.
Next, take a hard look at what’s going on in the economy, not the day to day beat but the pattern over time. Here we see strong corporate earnings–a dividend of the powerful government stimulus– but weakness in most current readings of activity. Goldman Sachs economist Ed McKelvey recently offered an update to the firm’s below-consensus economic forecast, noting that even its modest growth outlook is being hit with weaker than expected economic reports in areas like consumer spending. confidence, housing activity, durable goods orders, payrolls, etc. He nods to the positive surprises–industrial output and the Institute for Supply Management’s manufacturing index—but that hardly turns the tide.
On balance Goldman expects continued weakness in consumer spending and residential construction, a “stall” in industrial activity (because inventories are piling up) and another round of labor market weakness as business looks to protect margins in a period of poor economic growth.
Developed markets around the world are in different states of paralysis. Here’s how Carl Weinberg, chief economist at High Frequency Economics, describes the scene:
Our view on Euroland is decidedly bearish. we see those economies as credit-constrained, as are the economies of Britain and Japan. Fiscal stimulus is being withdrawn in each of these cases, further clouding the prospects for any economic growth at all as far forward as we or anyone else dares to look. The monetary and credit shocks to these economies are so great that the mechanism of normal enterprise and commerce has been disrupted, and it will remain so for a while.
So what should people be doing with their money at a time when visibility is so poor? In a word, diversify. That may sound like a useless suggestion because most people already take steps to diversify. If that’s the case, then it’s time to kick it up a notch as chef Emeril would say. Harvard, Yale and other big endowments have taken the diversification strategy to extremes that ordinary investors could never hope to achieve, utilizing derivatives, private equity, and other institutional products. But many of these more exotic investments no longer offer an edge. For everyone else, there’s plenty of diversification juice in the normal range of investments, from REITs to ETFs, some with global reach. Put another way, think of diversification as your fog horn–it won’t lead you to riches but it should keep you afloat until the skies clear.