Is the United States headed for a lost decade as far as the economy goes? And if so, what are the best investment strategies to deal with that torpor?
There is precedence for wasted economic decades. It happened in Latin America amid the region’s debt crisis in the 1980s, and it’s been going on for more than 20 years in Japan, which still hasn’t recovered from its bubble economy of the 1980s.
The U.S. economy is struggling to emerge from the 2008-2009 financial crisis after binging on debt and conspicuous consumption. Gross domestic product rose at an annual rate of 1 percent in the second quarter of 2011, according to the Bureau of Economic Analysis. It edged up just 0.4 percent in the first quarter.
“Our concern is that there could indeed be a lost decade,” says James Holtzman, a shareholder at Legend Financial Advisors in Pittsburgh.
Chris Litchfield, a private investor in Stamford, Conn., who formerly ran a hedge fund, estimates based on historical stock market patterns that the bear market that began in 2000 will last through 2014, providing an average annual return of about zero.
Whether our economic and financial morass lasts another four years, 10 or whatever period, experts recommend several strategies to weather the storm. There is one overriding imperative, they agree. “Diversify, diversify, diversify,” says Holtzman. Here are seven different ways to do that.
The most basic strategy
It doesn’t have to be complicated. Investors could stick all their assets in just two mutual funds or exchange-traded funds: a broad stock index fund and a broad bond index fund, says Ethan Anderson, senior portfolio manager at Rehmann Financial in Grand Rapids, Mich. Rebalancing this portfolio once a year would be fine for the average investor, he says.
The idea, of course, is to buy low and sell high. So after each year you might want to sell some of the fund that has performed best and buy some of the fund that has lagged, perhaps keeping your weighting at 60 percent stocks and 40 percent bonds. That’s the rule-of-thumb asset-allocation strategy for investors far from retirement.
You might want to vary your weightings if you think one fund is likely to far outperform the other, perhaps because it has lagged for a sustained period.
In a weak economic environment, stock prices are unlikely to rise much, and bond yields are likely to stay low. So you want to find other ways to produce income. One way is dividend stocks. Some conservative utility stocks are paying dividend yields of more than 4 percent, and some blue-chip multinationals offer yields above 5 percent.
Several studies indicate dividends have historically provided about 50 percent or more of the stock market’s total return.
“If we’re in a zero percent world (for stock market appreciation), and you can get 4 (percent) to 5 percent return up front, anything you can do beyond that (when stock prices finally rise) will just add to your positive rate of return,” Litchfield says.
But be careful in your stock selection. A high dividend yield can stem from a falling share price, which in turn could stem from problems at the company. A corporation that is devoting too much of its earnings to dividends — or worse, borrowing money to pay dividends — may not be paying them much longer.
“It’s definitely a case of buyer beware,” says Tim Ghriskey, chief investment officer at Solaris Asset Management in Bedford Hills, N.Y.
Master limited partnerships
Master limited partnerships represent another asset class that provides strong income. MLPs are companies that trade like stocks. The vast majority of MLPs are engaged in the transportation, distribution and storage of energy products — natural gas in most cases. MLPs now yield more than 6 percent on average, according to the Alerian MLP Index.
MLPs also provide a tax advantage because most of your quarterly income comes in the form of return of capital rather than in dividends. Therefore, the income isn’t subject to tax. Many MLPs are natural gas pipeline companies with long-term contracts, guaranteeing you income for years.
Demand for energy can obviously wane when the economy is weak, but natural gas has increased its share of the total electricity generated in this country to 24 percent from 17 percent 10 years ago, according to Solaris data. “And almost every (presidential) administration has promoted domestic energy production, so the wind is behind your back,” Ghriskey says.
But realize you’ll have to fill out copious K-1 tax forms, and tax rules make it unwise to hold MLPs in a retirement account. Also, the Alerian Index has more than doubled from its March 2009 low, so it’s unclear how much upside is left for MLP share prices.
While it will be difficult to find many bonds in the U.S. with attractive yields in a moribund economy, that probably won’t be the case overseas. This is true especially in some emerging markets where economies are booming.
Bonds in countries such as Brazil offer far higher yields than their counterparts in the U.S. You’ll want to purchase bonds in a fund, as buying them individually is generally prohibitively expensive. You can buy funds that specialize in developed country or emerging markets bonds.
With the dollar likely to drop further amid weak economic conditions, you’ll also gain a currency advantage in funds that don’t hedge their foreign exchange exposure, Holtzman says. That’s because the shares of these funds will be worth more in dollar terms as foreign currencies rise.
Bur remember that foreign markets — particularly emerging markets — can be quite volatile, and there’s no guarantee your foreign bond fund will produce a positive return.
Given the broad nature of the 2008-2009 financial crisis and the economic malaise that may be coming, “it will take more creative diversification than ever” for investors to optimize their portfolio, Holtzman says. So your diversification strategy should include alternative assets, such as commodities, currencies, managed futures and hedge fund-like mutual funds.
“Commodities, emerging market debt, long-short strategies in equity and fixed income: A lot of those strategies were only available through hedge funds in the past,” says James Shelton, chief investment officer of Kanaly Trust in Houston. “But there are a lot of mutual fund alternatives now. That’s good for smaller investors.”
If you have the traditional weighting of 60 percent stocks and 40 percent bonds, you might want to slice off 20 percent of the total for alternative assets, says Anderson. You can peel that money off your equity holdings to take a more aggressive or defensive stance through alternative assets, depending on market conditions.
Gold represents perhaps the hottest alternative investment now, with its price rising more than fivefold since the beginning of 2000. It recently approached $2,000 an ounce. Experts see several reasons for the precious metal to keep rising.
“Central banks around the world, particularly in emerging markets, are saying, ‘We’ve bought enough Treasuries now. We will put some of our reserves into gold,'” Shelton says. Central bank gold purchases in the first half of this year already have surpassed the total for all of 2010, according to the World Gold Council.
In addition, emerging market countries have a historical mistrust of paper currency, creating a natural demand for gold there, Litchfield says. And he sees good reason for that stance now.
“Currencies are being debased around the world by loose monetary policy, so gold is buying more and more of everything else. You can’t expect the Fed to expand its balance sheet from $800 billion to $3 trillion without consequences — and there will be,” Litchfield says.
Options and futures
Some advisers wax enthusiastic about managed futures funds. These funds use derivatives — mostly futures and options — to make bullish and bearish bets on everything from stocks to commodities. The Barclay CTA Index of managed futures funds gained an impressive 14 percent in 2008, while the Standard & Poor’s 500 index plummeted 37 percent.
But while the funds have produced annualized returns of 11.4 percent since 1980, their performance can be quite volatile. The Barclay Index fell 1.4 percent in the first half of the year, while the S&P 500 climbed 6 percent.
Long-short funds, which take long and short positions on stocks and other assets, represent another option. Even during bear markets, equities can rise for a time. “Look at Japan,” Shelton says. “There were numerous monstrous rallies during the long decline.”
A long-short fund obviously gives you the opportunity to profit from bull and bear markets. “That’s a decided advantage in higher risk markets,” Ghriskey says.
However, their success depends almost entirely on the investment prowess of a fund manager.