Chess Financial

As of this writing, the most probable (and optimistic) scenario is that the European Central Bank (ECB) agrees to act as the lender of last resort and embark on a program of buying as many sovereign bonds as necessary to stop the rise of eurozone interest rates (see chart below). In return, eurozone members would agree to a so-called fiscal union, which would control the deficits individual countries could run. The resulting austerity measures would probably push Europe into a recession but the global financial markets would likely experience a relief rally.

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.

With such formidable unknowns, and stock prices that are fairly valued, we think its only prudent to stick with the themes that have defined our general portfolio strategy over the past few years: broad diversification, high quality, reasonable expectations and patience. What this approach lacks in excitement, it should make up for by offering the prospect of capital preservation and a satisfactory return.

At the outset of the second quarter, the major trends that have shaped our portfolio strategy since last summer remain largely intact. These include: A global economy that is experiencing a two-track recovery. Growth in the developed markets is generally subdued while growth in the emerging markets is more robust. Inflationary pressures continue to build as evidenced by price increases in many commodities, notably food and oil. Interest rates have begun to move higher, either due to central bank actions (e.g., China, India) or specific country risks (e.g., Portugal).

Throughout history, our ancestors have demonstrated the ability to overcome the pressing issues of their era, usually through a combination of innovation and grit. This helps explain why the most pessimistic forecasts have rarely come to pass. Here are just a few innovations that could help us solve our pressing economic issues: Agricultural productivity, Renewable energy, Sustainable urbanization

The risk profile of stocks relative to bonds has improved markedly in recent months. Add to this the fact that the S&P component companies are holding almost one trillion dollars in cash and are trading at a reasonable multiple of current earnings, and we conclude that bonds will be hard-pressed to outperform stocks on a total-return basis in the decade ahead.

With most of the globe showing signs of economic recovery, and many developed countries facing heavy debt burdens, it is hard to imagine a future that does not include higher interest rates. Since bond prices move inversely to interest rates, most fixed-income investments will face a headwind sometime in the next few years. If this outlook for bonds is correct, it's likely that stocks will deliver better overall returns over the next 3-5 year market cycle. High-quality stocks offer the best risk-adjusted returns given their reasonable valuations and attractive dividends.

Three first principles of preserving and growing capital deserve our attention at this juncture in financial markets: Never own too much of any one investment, keep only those investments that offer the prospect of a reasonable return, and accept that financial markets will behave in a way that confounds the majority of people. These first principles speak to the importance of portfolio diversification, maintaining reasonable expectations and avoiding the latest fads. Turner also discusses prospects in the bond, stock, commodity and commercial real estate markets.

It is our expectation that the returns of the major assets classes will generally be lower and less correlated in the year ahead. We reach this conclusion based on several factors, the first of which