A lack of investor confidence exposes the inner workings of the financial markets like no theory or computer model can do. Without it, security prices lose a critical element of support – especially those assets deemed to be the most risky. This is precisely the behavior we witnessed during the third quarter.

This erosion of confidence is understandable. Our own economy is struggling to grow and the European debt crisis is intensifying. This latter factor has raised fears that a number of large European banks may not be sufficiently capitalized to survive a sovereign default.

Predictably, investors have rushed headlong into “safe havens” like gold, Treasuries and the Swiss franc. Yet, in the process of doing so they may have inadvertently set themselves up for disappointment down the road. As one example, with 10-year Treasuries now yielding 2 percent and core inflation running at 1.8 percent, an investor’s real, after-tax return doesn’t seem too attractive unless your time horizon is very short or you believe that deflation is in our future.

So the lesson we draw from the third quarter is that safety has become expensive and risk more affordable. Therefore, we’re probably at the point in this cycle where it makes sense to consider adding risk to portfolios. However, until the specters of a double-dip recession and credit contagion have diminished, this shift needs to be incremental. The key is to make sure that you have the financial flexibility to take on more risk and the wherewithal to hold on until market conditions improve.

From our perspective, the most obvious choice to add risk to a portfolio is large-cap, dividend-paying companies. Generally speaking, these companies are in the strongest financial position they’ve been in for decades. As a result of the market sell-off, many of their stocks yield considerably more than 10-year Treasuries, with the prospect of dividend increases in the years ahead. It’s also worth noting that the number of share purchases by corporate insiders and companies themselves has increased markedly. This suggests that knowledgeable investors see value at these price levels.

Commodities represent our second choice for increasing a portfolio’s risk. Like stocks, commodities have been subject to widespread selling. But if we consider just the increasing demand from the developing world, it’s hard for us to imagine a future that doesn’t include higher prices for most commodities. A modest economic recovery in the developed world would only accelerate this trend.

In previous newsletters, we have discussed the tendency of investors to extrapolate recent experience, and how this causes them to act most decisively near inflection points. Today, investors are selling assets they perceive to be risky to buy assets they perceive to be safe. Along the way, they seem to have forgotten that even safe havens can fall victim to speculative excess. How long this trend will continue is unknowable. However, the longer it persists, the more likely it is that risk assets will prove to be the better investment.

 

 

 

(c) Chess Financial

www.chessfinancial.com