Broadly speaking, I like Baron Rothschild’s model portfolio weighting: one-third securities, one-third real estate, and one-third art.  (Personally, I’m nowhere near that allocation.)  But effective asset allocation is getting harder and harder because it’s difficult to find assets that are uncorrelated, which is the key to better portfolio and risk management.  Therefore, especially in today’s challenging market, it’s more essential than ever to be thinking at least a bit outside of the box to achieve real diversification.

For a more specific look, it may be easier to start off by saying where I would not invest. It may seem counterintuitive, but the prudent investor doesn’t want to be too exposed to longer-term US government bonds.  At some point, there’s going to be a shift in sentiment against these securities, and it could be that right now we are very close to the top in demand and price for the 10-year Treasuries, which are now yielding less than 3 percent.

I’m also bearish about European government bonds because I believe there is going to be a widening of spreads, especially in the euro area. 

Real estate will continue being a minefield, especially commercial property, which is just starting to get hit.  This is not going to be a period in which I buy my Manhattan apartment. And I don’t expect US real estate to bottom out much before the middle of next year.

As for commodities, I would be short rather than long.  And longer term I believe the dollar is a horror show with a lot of currency volatility next year as US bond prices and currencies are repriced.

This in part makes a case for foreign exposure.  The most compelling segment of the global economy at this moment is some of the emerging equity markets where valuations appear to be very cheap.  If there is going to be any meaningful growth at all over the next 4 or 5 years, it will be in China, its neighbors, and certain Latin American economies such as Chile and Brazil. I like these markets now.  But I would avoid Eastern Europe, along with markets that are exposed to above average political risk.

I also like some corporate bonds in fiscally prudent markets.

But whether it’s stocks or debt, investors need to differentiate among various submarkets. Don’t expect broad-based index exposure to work.

If the Bank of England estimates global toxic assets at $2.8 trillion and recognized write-downs are only about $500 billion, everybody knows that there’s a lot more trouble to come.  And this makes the banks very wary of one another.  It’s as if the banks were men nursing very grave wounds, looking at one another wondering, “who’s going to be the first to die.”  Not a great basis for long-term relationships or trust.

We will only see a return to healthy interbank lending when there has been a full and credible disclosure of losses.  We are long way from that.  And that’s a very difficult conversation to have because such full and frank disclosure of market losses at this point would likely destroy a very large number of institutions, I suspect.  So we are in a twilight world where the full scale of the damage on balance sheets is being repressed. 

Under normal circumstances, the US bankruptcy system works effectively to allow insolvent firms to restructure and get back on their feet.  But now that would be very hard to do indeed.  So, temporary extension of credit is understandable.  You don’t want major industries to collapse on the cusp of a major recession.

But over the long term I worry about the suppression of the evolutionary process with government assistance preventing failure and consolidations from taking place to clear out the debris and pave the way to healthier markets.  Intervention could delay the inevitable, protracting the suffering.  Creative destruction has its place.  But if everyone but Lehman Brothers is too big to fail, then we aren’t in a good place.

I’m not happy with the terms of Citigroup deal.  It’s too open and more guarantees may be needed.  Someone described it as one of the biggest option trades in history.  The government is writing some very big blank checks based on the belief that bank management knows what they are doing.  Unfortunately, I’m not certain of that.  The conglomerate financial model Sandy Weill conceived hasn’t worked.  And I would be amazed and seriously depressed if Citigroup remains in its present form 12 months from now.

We need a serious restructuring in the US financial sector.  So, one of the most important jobs of the incoming administration is to come up with an approach that’s different from the blank check model. 

The good news is that there are a number of up and coming institutions that are smaller and not so leveraged banks that can step up and start filling in the spaces vacated by the larger, more troubled institutions.  I still have some faith in the powers of the US to renew itself. 

But ultimately, what we can achieve from the money being injected into the system is only the avoidance of massive bank failures and monetary implosion.  Broadly speaking, we can’t breathe life back into the dinosaurs. But we are trying to make their death as painless as possible.