Thursday, December 22, 2011

Looking Ahead - Reluctantly

I have written several times over the past few weeks about the futility of forecasting.

However, investing is all about preparing for the future, so I want to share what I have been telling clients recently.

The basis of my strategy for 2012 comes from Ray Dalio, founder and president of Bridgewater Associates.

Bridgewater is the largest and one of the most successful hedge fund operators in the world. Managing $125 billion for large institutions and pension funds, Bridgewater's investment returns have consistently been among the best in the investment world.

Dalio wrote an editorial piece in the Financial Times in late October discussing the current state of the world. Here's how I described it in my post dated October 25, 2011:

Dalio believes there are three important trends to consider right now:
  1. We are in the midst of a massive de-leveraging process. Dalio notes that he is not only concerned about the huge government debts around the globe, but also the massive amount of debt that individuals also have amassed. In his opinion, the process of reducing this debt will be a drag on economic growth for years;
  2. Governments are largely out of ammunition. Dalio believes there is are few alternatives left for our elected officials to improve the current economic climate;
  3. We are at each other's throats. The tone of any policy debate has become incredibly nasty and strident, and no one seems to want to try to come up with any workable solutions. This, in Dalio's opinion, is probably the biggest danger to our economies and markets.
Here's the final paragraph of Dalio op-ed piece:

If we calm down and work together to properly manage this difficult situation....we can get through this deleveraging without great pain. If we can't, we may experience an economic, social and political collapse.

The reason I like Dalio's logic is that I believe it sets a very reasonable framework for investment strategies.

For example, in a world characterized by deleveraging, lenders are obviously at a disadvantage - hence, I would continue to avoid bank stocks.

Deleveraging - combined with massive liquidity injections by the central banks of the world - also means that the price of money will remain relatively cheap. Thus, interest rates will probably remain low for longer than people expect. Bonds will offer a good buffer if markets turn ugly, but returns can only be modest from today's starting levels.

Low interest rates also raise the attractiveness of dividend-paying stocks.

Points two and three relate to government policy.

Fed interventions in markets during the past two years were crucial for many reasons, but they were a major contributor to capital market returns.

Do you think it was just coincidence that the stock market swoon this summer came shortly after the end of the Fed's second round of quantitative easing? I don't.

But I would agree with Dalio - I doubt that the Fed could muster the political support for another massive market intervention except under the most dire scenarios. Investments in 2012 will rise or fall based on their own merits - no Ben Bernanke to the rescue.

The final point is being illustrated once again in Washington. I don't know where you stand on this whole debate on extending the payroll tax cut, but the partisan bickering is once again discouraging.

It's hard to believe that our political system will function any better next year, when Presidential campaigns are in full swing. Problem is, partisan politics could lead to poor policy decisions, and this to me is one of the major risks to investors next year.