Opposing Forces

Two widely divergent forces are currently impacting investment markets.

On the downside is the challenging reality.  The pace of the U.S. economic recovery remains sluggish and the threat of a recession in the coming months is rising.  Looking abroad, policy makers have struggled for well over a year to contain the European crisis, but the situation continues to deteriorate.  Greece is teetering on the brink of default and problems are worsening in major sovereigns such as Italy, Spain and even France.  The end result in Europe may ultimately lead to another global financial contagion.  The threat of such an outcome is deeply negative for risk assets such as stocks, but would benefit safe haven assets such as U.S. Treasuries and Gold.

On the upside is the hope by investors that the U.S. Federal Reserve (the Fed) will intervene with more aggressive monetary support.  The most recent Fed stimulus program known as QE2 ended on June 30.  And stocks began plunging sharply within weeks after the end of QE2, declining by nearly -20% from July 22 to August 8.  But then the Fed stepped in with a new round of stimulus by promising to keep interest rates at 0% until mid-2013.  This helped put a floor under the market.  After stocks went on to thrash back and forth through August and September, the Fed launched another stimulus program known as Operation Twist at the beginning of October, and stocks have rallied by +14% in the weeks since.  Finally, the Fed just this past Wednesday strongly suggested that yet another round of stimulus in QE3 would soon be on its way.  Stocks tend to react euphorically to Fed stimulus, so this aggressive outpouring of monetary support has certainly helped to offset the extreme risks currently facing the market to this point.

These two strongly opposing forces have resulted in a wildly volatile market environment on a day-to-day basis.  On days when investors are optimistic about the U.S. outlook or believe the situation in Europe may be headed toward a resolution, the stock market soars.  But on days when it appears that the situation may be set to unravel Europe or the economy is weakening in the U.S., stocks plunge sharply.  Such dramatic up and down shifts have been occurring daily if not hourly during any given trading session.

Given these diametrically opposing forces, two very different outcomes both appear high probable in the coming months.  The first would be the outbreak of a full blown crisis in Europe and a recession in the U.S., which would likely push stocks sharply lower.  The second would be a stabilization of the situation in Europe, which would instead allow the forces of Fed stimulus to propel stocks sharply higher.

The meaningful probability associated with these two widely divergent outcomes emphasizes the importance of maintaining portfolio hedging strategies to navigate the current environment.  Recent portfolio adjustments in response to this backdrop include shifting away from exposures that would be too heavily impacted by one single outcome.  Relating it to a seesaw, it is the equivalent of moving away from either end of the lever and toward the fulcrum.  This includes exiting positions in nominal U.S. Treasuries and more economically sensitive stocks toward positions such as Treasury Inflation Protected Securities (TIPS), Gold and selected defensive stocks that stand to benefit from either outcome.  The emphasis of such a risk controlled strategy is to neutralize the potential downside while also capturing the upside opportunity associated with either outcome.

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