Portfolio Prognostications for Uncertain Times

Once an investor has decided which way the economy is going, history offers plenty of allocation tips. The trick is calling the trend right

By Christopher Farrell

It's hard to read the direction of the economy these days. No wonder investors are so grumpy. The stock market is flailing lower, despite the Federal Reserve Board cutting its benchmark interest rate another quarter point on Aug. 21. Foreign economies are crumbling, American companies are still chopping their capital spending plans, and the corporate profit outlook is murky.

The Fed has lowered rates seven times this year to stave off recession. And there are some signs the monetary easing is working. Retail sales are strong, new claims for unemployment insurance are down, and housing starts are up. So which indicators are right? Wall Street is weary of wrestling with the prognosticator's question, "recovery or recession?"

Of course, there's nothing individual investors can do to eliminate the excruciating economic uncertainty. But the most reasonable bet is that a recovery will unfold sooner rather than later. Now is a good time to take another look at your portfolio in anticipation of an economic upturn. The millions of individual investors saving for their retirement in a 401(k) plan or Individual Retirement Account (IRA) can shape their financial future by revisiting the one investment decision that truly matters: Asset allocation.


  Economic studies suggest that for all the time people spend trying to pick the right stocks or mutual funds offered in a defined contribution pension plan, it's how the investment portfolio is divided among stocks, bonds, cash, and other assets that mainly determines a portfolio's long-term performance. And this is particularly true relative to price stability -- or the lack thereof during a given time period, according to a recent Morgan Stanley study of how 25 different assets performed during different pricing conditions.

Let's say inflation stays down when the economy improves. And what if the price level 10 years from now is the same or a fraction lower? The combination of intense global competition and high-tech innovation suggest that the virtual disappearance of corporate pricing power is a structural change in the economy, rather than a reaction to a weak economy. If that's the case, bonds and cash will give stocks a run for the money.

According to the study by David M. Darst, a managing director at Morgan Stanley, the consumer price index (CPI), the government's broadest inflation gauge, fell at a 1.5% annual rate from 1871 to 1896. Stocks returned 5.5%, bonds 6.4%, and cash 5.4%. From 1899 to 1915, the CPI rose at a 1.3% pace, and stocks gained 8.2%, bonds 4.1%, and cash 5.3%. In other words, diversifiers are amply rewarded for their conservative investment strategy -- when inflation stays tame.

Darst's study sliced and diced the return data for assets ranging from U.S. equities to U.S. farmland to foreign bonds. He organized the data in a number of different ways, but the most intriguing aspect of his research -- and the part that seemed most appropriate right now -- is how different securities performed in different economic environments. Specifically, Darst divided U.S. economic history from 1871 to the present into four major types of economic conditions: deflation, price stability, disinflation and moderate inflation, and rapid inflation.


  If you believe the ominous parallels that some Wall Street analysts are drawing between economic conditions now and those during the Great Depression, you'd want to load up on government bonds and cash. From 1929 to 1932, the CPI fell 6.4% a year. Bonds returned 5% and cash 3% during those early Depression years while stocks lost 21.2%.

Alternatively, let's say you believe inflation will roar back, perhaps reminiscent of the 8.1% average annual surge in the CPI from 1971 to 1981. Market history suggests a smart asset allocation would be to cut back on equities (a 5.8% average annual return from 1971 to 1981), and hike your exposure to hard assets, such as gold (24.8%), silver (18%), farmland (16.4%), and housing (12.1%).

Of course, the right mix of assets largely depends on an individual's tolerance for downturns in the market, the need for income, the investment time horizon, and other personal financial characteristics. Many investors learned the hard way during the demise of the great bull market that their willingness to take risk was less than they thought -- and their need for cash greater than they expected.


  And while past investment performance is no guarantee of future results, it's probably safe to say that equities should remain the core investment in any retirement portfolio even though short-term U.S. Treasury bills and other cash equivalents have outperformed common stocks the past three years.

The reality is that investors saving for their retirement should assume that the business cycle will turn in a more positive direction. That's a given. The harder issue to take a stand on, and the one with genuine investment implications, is what will prices do during the next economic expansion? My vote is for price stability, after adjusting for the swings in the business cycle. If so, it's wise to diversify into bonds and money market assets, which generally reduces a portfolio's risk as well as improves the probability of achieving a good average long-term return.

Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BW Online

Edited by Beth Belton

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