Cold Turkey

Watching the U.S. capital markets on a daily basis has become akin to riding a roller coaster, up and down with a few twists and turns thrown in for good measure. Investors had better get used to it. The markets are responding to economic data. The economic data is going to be mixed going forward. The net result should be a mild, but fundamentally sound, recovery. However, because government stimulus has been driving the recovery in the financial, manufacturing and housing sectors, we could see the pace of the recovery slow as the stimulus is removed.

This is not sitting well with some economists, financial media pundits and equity market participants. To them a sharp V-shaped recovery is almost an inalienable right. Due to the tendency for people to have short-term historical perspectives, a sharp V-shaped recovery is expected because that is what "always" happens. Although it is true that recent recoveries have been sharp and V-shaped, there is nothing written which states that is how it always has to be. In fact, the Fed's (and other areas of the government) reluctance to allow the economy to revert to an unstimulated pace of growth by engaging in very accommodative monetary policies at the sign of an economic slowdown created artificially sharp recoveries. The economy was never permitted to come down from its growth binge. As soon as the signs of an economic hangover were showing the Fed gave it more of the hair of the dog.

Now the Fed's whiskey barrel is empty. Last year was the pounding hangover. 2010 is the difficult recovery, but recover we will. Just as the bulls were too optimistic, the bears may be too pessimistic. The U.S. economy is the most dynamic in the world. Only bad policy emanating from Congress can impede the recovery. Some of the proposed regulatory changes and current policies are not conducive to a strong economic recovery. How much money are we going to pump into GMAC and do we need Czars? This is America damn it!

I believe the U.S. economy will grow in the 2.25% to 2.75% range in 2010 and for the balance of the next decade. It is not to what we have become accustomed, but it is sustainable. The Fed would love to juice growth, but it is out of economic spirits. The sooner the economy goes cold turkey the better.

So where should investors look to place capital in 2010? My opinion has not changed. Heading toward year-end 2009 I was of the opinion that the run up in the equity markets and credit markets were about finished. I still believe that. Pimco's Bill Gross recently stated that he is moving capital out of corporate and treasury bonds. I agree with Bill. In fact I was stating that these bonds had run too far, to quickly late last year and took a short position on the long end of the treasury curve. The biggest difference between Bill and myself (besides our levels of compensation and public notoriety) is that I told you in a timely manner and Bill told you after he made his trades. One can make a lot of money investing with Bill Gross, but not nearly as much by acting on his free, but less timely, information.

Fixed Income investors should play defense by investing in higher quality securities and keeping average duration to about five to seven years. this does not mean that one should put all one's capital on that area of the curve. Spread it out, but keep the average duration (as opposed to maturity) in the five to seven year area of the curve. Using higher-coupon bonds and preferreds helps to lower duration. This also does not mean that investors should not invest in lower quality securities. Investors who can tolerate the risk and volatility of such investments may want to strategically include lower-rated bonds in an otherwise high-quality portfolio. Do your homework when investing in high yield bonds. They are not created equal.

This should give my readers a good starting point for investing in 2010. As always, questions regarding specific investments and strategies are always welcomed. I am only an e-mail away.