AA Is The New AAA.

AA Is The New AAA.

In other words, Standard & Poor’s U.S. Debt downgrade doesn’t change a thing.

America’s loss of its Standard & Poor’s AAA debt rating on Friday will continue to provoke strong reactions, from markets and pundits alike. But nothing has really changed.

Now is not the time to give in to emotions and make rash moves. It's the time to take a few deep breaths and dispassionately set a sensible course for the future.

Let's start with a little perspective. Yes, the fact that U.S. debt no longer carries a top triple-A rating is troubling. But it's not as if S&P told investors something they didn't know before (i.e; that the country's long-term finances are a mess).

As for the economic effect the downgrade might have, that's far from clear. Ultimately, though, bond investors' expectations will be the primary determinant of the yields on Treasury bonds, not the opinion of the ratings agencies.

And, so far, investors seem to be rushing into Treasuries not away from them. So I think people may be overreacting to the whole downgrade thing.

That said, whether the sell-off was an overreaction to the downgrade, the growing sense that the economy may be weaker than previously thought or something else, investors have clearly shown they're extremely nervous about stocks.

But this isn't exactly news either.

Although we lose sight of it from time to time, the fact is that the stock market is and always has been a very volatile place.

The flip side of that volatility, though, is that stocks have also generated some pretty impressive long-term returns. If you look at the 56 rolling 30-year periods from 1926 through 2010 (1926-1955, 1927-1956, etc. through 1981-2010) the lowest annualized return stocks have delivered over a 30-year span is 8.5%, and the average 30-year annualized return for all those periods is 11.3%. For bonds, the numbers are 1.5% and 5.1%, respectively.

This doesn't mean stocks will generate the same gains over the next 30 years. I wouldn't be surprised to see them come in considerably lower.

But I don't see any reason why, over the long term, one would expect stocks to underperform bonds or cash, especially considering the current low yields on bonds and cash equivalents. Remember, just yesterday the U.S. Federal Reserve vowed to keep interest rates at close to zero for the next two years.

So it seems to me that the challenge for someone investing his nest egg today is still pretty much what it was before all the debt-ceiling-downgrade political drama: to participate in stocks' long-term growth without getting hammered too badly when stocks suffer their inevitable periodic declines.

There are two ways you can try to do that. One is to attempt to outguess the market — that is, capitalize on stocks when they're doing well and then move out of them into bonds or cash or gold or whatever to avoid downturns.

The other is to invest in a reasonable mix of stocks and bonds and basically stick to it, allowing the bond portion of your portfolio to dampen stocks' swings. The first approach — moving in, out and around various parts of the market — is difficult-to-impossible to pull off consistently.

If you doubt that, just consider recent events. In the weeks leading up to August 2, investors' biggest fear was that Congress and the Obama administration might fail to raise the debt ceiling on time and thus spark a stock-market meltdown.

People were so convinced that this would threaten their portfolios that many considered moving their money into cash to protect against that possibility. When Congress and the White House reached a deal before the Tuesday deadline, the big market swoon everyone feared was averted.

However, two days later, while investors were still feeling good about dodging the debt-limit bullet, the Dow plummeted 510 points on concerns about the European debt crisis and the possibility of the U.S. sliding back into recession.

And then came Monday's wild 635-point Dow free fall in the wake of S&P's downgrades.
My point is that you can never really tell what might initiate a market decline — let alone know when it might occur.

The more sensible way to participate in stocks' long-term growth is to create a mix of stocks and bonds that gives you the benefit of the balance of probabilities at solid returns and offers at least some protection.

The longer away you are from retirement and the more your stomach can handle the value of your retirement savings taking the occasional decline, the more you can devote to stocks.

The closer you are to retirement and the more upset you get when your nest egg gets scrambled, the more you should tilt toward bonds and cash. If you're on the verge of retirement, that mix might be somewhere around half in stocks and half in bonds.

Taking the asset allocation approach and sticking with it (except for periodic rebalancing) won't immunize you against losses. But it can help you manage the downside risk of stocks without giving up all the upside.

And, more importantly, it gives you a rational way of dealing with the stock market's volatility and keeping downturns to a magnitude you can handle, rather than engaging in a never-ending guessing game.

By trying out different blends and seeing what sort of losses they incurred, you can get a better feel for what stocks-bonds allocation might be right for you.

Remember, though, if you go with too conservative a strategy to guard against market downturns, you limit your upside. So to get a sense of whether the asset allocation you choose will give you a large enough nest egg to support you in retirement, I suggest you use many of the excellent retirement income calculators available for free through many respected financial websites and investment companies.

I don't want to downplay the seriousness of the situation facing investors today. We could very well see lots more turmoil in the financial markets and further declines in stock prices.

But the fact is that there will always be something going on that investors will feel compelled to react to, whether it's the threat of a recession triggering a market meltdown or, in better times, rosy reports of economic growth and corporate profits suggesting the markets will soar.

But if you invest on the basis of hunches and speculation rather than setting a coherent long-term strategy and sticking to it, you'll put yourself at risk of selling after prices have already fallen and buying back in when prices are already inflated.

In the end, that will make it tougher for you to earn the returns you'll need to build a decent nest egg and harder for you to maintain your emotional equilibrium in tumultuous times like these.

2011 Outlook

“Prediction is very difficult, especially about the future.” -- Niels Bohr

While 2010 was a respectable year, and in a few instances an excellent one, for most financial markets, it came with the sobering realization that many of the global imbalances investors thought were behind us remain, albeit in a slightly altered form. Which leaves the question; will 2011 be the year when these imbalances re-erupt? I believe the answer is no, at least not during the next 12 months.

For 2011, I believe the overall global economic environment is likely to remain conducive for risky assets. I would expect developed markets to stage steady, yet uninspiring recovery. Growth should be subdued but positive, with inflation remaining low. While rates will rise over time, given low inflation and anemic demand for capital from everyone except sovereign borrowers, I believe bond markets will remain stable enough so as not to derail the equity market rally. In emerging markets, I would continue to expect outsized growth, although that growth is likely to slow as emerging market central banks wrestle with inflationary pressures.

For investors, this means considering an overweight to equities and continued exposure to commodities, particularly the more cyclically oriented ones. Within credit, investors should consider overweighting corporate credit versus sovereign credit.

While cyclical factors should support financial markets for another year, to be clear I don’t believe that the market’s bottom in 2009 marked the beginning of a new cyclical bull market. The debt problems that derailed the global economy in 2007 are largely still present; they have simply morphed from the private to the public balance sheet. Government unwillingness to address these issues, particularly in the U.S., leaves both equities and bond markets vulnerable in the long-term to wrenching fiscal austerity, unexpected inflation, or potentially both. Fortunately, that pending crisis looks like it can be postponed for at least another year.

Volatility

A little over three years ago, the Dow Industrials and the TSX hit an all time high and the list of established Wall Street firms still included Lehman Brothers, Bear Stearns, and Merrill Lynch. In the summer of 2008, most financial participants believed the worst of the subprime crisis had been experienced, world equity markets had recovered, and the US Federal Reserve (Fed) was grappling with the highest inflation in decades. A little over a year ago, financial leaders struggled to prevent what seemed like an inevitable slide toward the first global depression in 80 years.

Three years, three different market environments that experts were mistakenly confident would continue. Extrapolating from the past is a dangerous exercise during even the best and most stable of times. During periods of volatility, it is simple folly. Today, it is no illusion that the world has become more volatile. Consider the following: 10-year trailing U.S. inflation volatility is at a 50+ year high, over the past two years dollar volatility is the highest on record, and gold prices are the most volatile they have been since the mid-1980’s.

Nor is the recent volatility limited to financial markets. The volatility in asset prices has coincided with – orguably been caused by – a similar spike in political instability. The U.S. Congress has changed hands --- Republican to Democrat and back again – twice in a six-year period. This has not happened since the 1950s. At the same time, the U.S. Federal Reserve has tripled the size of its balance sheet over the past thirty months, and plans to continue this exercise through at least the middle of 2011. Outside the United States, the tenure of Japanese prime ministers is starting to resemble that of Italian ones, and an indecisive election in the United Kingdom has produced the first coalition government since the Second World War. Canada and Ireland have minority governments. Politically, economically, and financially we are living in an age of renewed volatility.

The one unqualified prediction that I will make for 2011 is that economic and political volatility will continue. There are three reasons to believe this.

First, many of the global imbalances which precipitated the previous crisis are still around, albeit in slightly altered forms. Instead of a pending subprime meltdown, we have the growing risk of sovereign debt, which will be further exacerbated by aging populations and unsustainable entitlement spending in much of the developed world.

Second, the aftermath of financial bubbles is characterized by slow, anemic recoveries in both economic growth and housing. Both of these will contribute to overall economic and political volatility.

Finally, the ongoing economic shift from developing to emerging markets will be a slow process, one that is likely to play out over decades. As it does, there are likely to be accompanying growing pains.

The good news for investors in the near term is that many of the longer-term imbalances still facing the global economy are unlikely to erupt over the next 12 months. So my baseline view for 2011 is a temporary lull followed by a lackluster but steady recovery in the developed markets with continued low inflation. In the emerging markets, we would expect continued strong economic growth. All things considered, not a bad environment for global equity markets.

Bonds are likely to hold up, at least through the first half of the year, but given valuations and supply issues they don’t appear to offer the best value.

It is important to note that the relatively sanguine outlook for next year does not imply that the global economy has put its troubles behind it. On the contrary, many of the structural imbalances that pushed us into the global crisis are still with us, albeit in an altered form. Ironically, many of the policies that are likely to promote a decent year for economies and markets, i.e. extension of the Bush tax cuts and maintaining transfer payments to individuals (employment benefits in the U.S.), will exacerbate the longer-term imbalances. At some point, the strain is likely to begin to show even on the largest and richest nations, but that is probably not an issue for 2011.