Sextant Investment Advisors

Going into the Summit, very little progress was anticipated thanks to clearly crafted statements from Merkel and other northern ministers. But apparently some fast talking from Monti and other leaders, such as the new French President Francois Hollande, resulted in some new concessions by Merkel. However, additional money did not find its way "South" and the concessions, while potentially significant, do not come close to solving the debt issues facing the European Union.

if I were given a time horizon of 10 years or more and had only two options, own 100% bonds or 100% stocks, I would choose stocks. But we are not limited to those two choices. The current fragility of the global economic and financial environments will surely create opportunities for investors to shift funds between asset classes in a way that should substantially improve their risk-adjusted rates of return over the next ~10 years. With equities, individual stock selection also provides investors with real possibilities to earn an acceptable rate of return now.

As we set expectations for 2012, the global financial markets are no less complicated but expected returns for most asset classes are even lower now than when we started 2011 making our jobs that much more difficult. The margin for error has narrowed. For fixed income investors, returns of 2 or 3% will probably look pretty good this year and next. Equity managers will need to be focused on stock selection with an emphasis on companies that possess very strong balance sheets, stable cash flows and price valuations with low expectations built in.

We sit today on the eve of the Great European Summit. The Summit to end all summits with Germany and France promising to deliver a magical array of policies and elixirs sure to cure the ills facing the 17-member currency union. Despite the potential peril that would accompany any less than a successful summit, stock market investors seem content to demonstrate a willing suspension of disbelief. Even some bond investors seem to be taken in by the recent news out of Europe.

It is hard to know now whether deflationary or inflationary forces will prevail. But we dont have to know. I do not expect that central banks will be able to get monetary policy just right and so it is clear to me that the current environment of low, stable inflation around the world is going to be short lived. This outlook combined with the extremely low interest rate environment cause us to focus on the preservation of capital. Avoiding losses is very important now. With yields so low, offsetting or recouping any losses is very difficult and would take much longer than is typical.

Since 2008, fiscal and monetary authorities around the globe have been clamoring for more and more cowbell, government generated stimulus and financial support. But there are increasingly clear signs now that the effectiveness of more cowbell is on the wane while opposition to more cowbell is on the rise. In a world with no more cowbell, cash and high quality assets are good places to hide out in anticipation of greater opportunities to profit from market uncertainty. While it may be true that we should not fear the Reaper, a healthy dose of skepticism is essential.

With the announcement of $600 bn in new QE this week, Fed quarterback Bernanke has dropped back deep into the pocket and launched a last ditch Hail Mary pass with the hopes of stimulating growth to bring down persistently high unemployment. There is one major problem this view. The magnitude of the debt overhang is far greater now than at any other time in history, making the relatively trivial QE1, QE2, QE3, etc. ultimately doomed to failure. For those with a long-term approach to asset allocation, chasing a hot asset class or reacting to a 'clueless' Fed policy is not an option.

Recent earnings growth stems from the economic leadership of developing countries from Asia to Latin America. When those economies soften, the recent improvement in earnings will be called into question. Meanwhile, with interest rates already at rock bottom, equity prices are even more susceptible to future earnings hiccups. The most profitable investment approach over the next several years will therefore be to reduce risk following periods of strong returns, and add risk only when markets have weakened sufficiently.

If billionaire money manager John Paulson is correct, and inflation reaches low double-digits by 2012, the discount rate used by investors to estimate the present value of their stock investments will rise sharply, which will have a very negative impact on equity prices as present value calculations decline. Sure, companies will be able to pass along price hikes and inflation should have a positive impact on nominal earnings growth, but the higher discount rate will overwhelm any benefit to the bottom line.

Longer-term interest rates may not be particularly cheap right now, but there is no indication that a bond bubble has formed and is ready to pop. When it comes to predicting what the global economy will look like in 2011 or 2012, there is still considerable uncertainty and at least some tangible risk deflationary pressures will continue to build. With yields on 10-year U.S. Treasury bonds under 3 percent, investors are not being paid enough to totally embrace long-term maturities, but to shun them altogether would not be a prudent decision either.

On the surface it seems the markets are experiencing a relative period of calm with equity prices about flat year-to-date and up around 10 percent versus a year ago. The credit markets have also stabilized since the second quarter when it appeared that one or more of the European countries could be forced into defaulting on their debts. However, a look beneath the surface shows some very deep and turbulent cross-currents.