Asset Allocation In An Unprecedented Economic Environment
August 18, 2010
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That is impossible to know. The more likely scenario is that the economy does not deviate too far from its current sluggish pace. But the risks of a more pronounced downturn should not be taken lightly. Uncertainty about the economy, which is linked to uncertainty about the policy environment that will result from the mid-term elections, is the main reason risk aversion has returned in the financial markets.
What would recession imply for
In the correction from the April highs,
In that scenario, how much downside risk is there in the stock market?
According to conservative valuation techniques such as the Shiller P/E Ratio, fair value on the S&P 500 is around 900. The combination of abundant liquidity provided by the Federal Reserve and the shortage of attractive investment alternatives in bonds should provide a floor around this level, and prevent stock prices from moving deeply into undervalued territory, which has tended to happen in previous secular bear markets. A return to the lows of March 2009 under 700 on the S&P 500 is very unlikely given the unprecedented stimulus and financial system support that has been applied globally.
What is a reasonable upside target if we avoid recession?
Until the private sector employment backdrop materially improves, the upside in
How much of a threat is deflation?
Deflation fears are overblown. We have been and continue to be in an environment where inflationary and deflationary forces operate simultaneously. Private sector deleveraging and excess capacity are deflationary. The government policy response of deficit spending and monetary easing is inflationary. The current deflation scare is unfortunate because it is leading to more monetary easing from the Federal Reserve, which is not what the economy needs right now. Interest rates are low enough. They are too low in the case of a zero percent federal funds rate. Europe has as many problems as the
What is the appropriate investment strategy for this environment?
This is not an environment to take an aggressive position on a particular outcome because there so many unpredictable variables. The indicators we track, which include fundamental, technical, psychological, and monetary factors, are mixed. Rather than black or white, we see a lot of gray. Our portfolios are well diversified with a defensive orientation. The primary secular risk remains the debt problem, which has been three decades in the making, and totals over 300% of GDP. A lot of deleveraging still needs to occur in the private sector, and governments need to get on a sustainable longer-term fiscal path. Investors are rightly skeptical about whether the political climate exists to begin to get our fiscal house in order while still fostering private sector growth.