The Markets at the Beginning of February

Good column this morning about the current market environment by Richard Milne in the Financial Times.

The consensus view is that stocks should have a good year in 2011. Corporate earnings are improving (despite lackluster sales growth); Fed policy remains extremely friendly; and alternative investments like bonds offer only modest returns. Moreover, historically the third year of a presidential cycle nearly always has offered investors attractive stock market returns.

At the same time, there are enormous problems still remaining in the economy.

Unemployment rates are very high, and there is little prospect that employment will increase dramatically any time soon (a fact even acknowledged by Treasury Secretary Geithner last week). Housing remains a mess, and probably will be for several years.

Municipal and federal deficits are unsustainably high, and will need to be addressed at some point in the very near future through some combination of higher taxes and lower spending, which will act as a drag on economic growth.

So what's an investor to do?

My own opinion is that you have to stay invested, particularly for the first part of this year. Valuations on quality large cap companies in particular stand out as appealing, not to mention the fact that dividend yields on many of these stocks are far higher than bonds issued by the same companies.

But around mid-year I think investors would be wise to heed the advice of Jeremy Grantham of the investment firm GMO.

Mr. Grantham is one of the more astute investment strategists out there, and he is always worth a listen. Here's today's column in the FT reports that his most recent strategy piece contains the following advice:

So what are investors to do? In Mr. Grantham's latest note called "Pavlov's Bulls" - about how the market salivates on cue ahead of any promised government stimulus - he warns that "you are living on borrowed time as a bull" with the S&P 500 worth only 910 rather than its current level of 1,280. His advice? "The speed with which you should pull back from the market as it advances into dangerously overpriced territory this year is more of an art than a science, but by October 1 you should probably be thinking much more conservatively."
FT.com / Markets / Insight - Why investors have adopted teenage temperaments

I would add one final point. In a world where unexpected events can change the investment landscape dramatically in a heartbeat (e.g. as I mentioned yesterday, we are watching events in Egypt very closely), a diversified portfolio makes more sense than ever.