Friday, April 4, 2014

Perfect storm and diversification

Recent talk has been about the poor investment combination of a high valued stock market and low historical yields in bonds markets. There is no diversification protection for the investor who wants to hold the classic, (you guessed it), 60/40 stock bonds mix against this perfect storm. Protection will only occur because the sensitivities of these two asset classes to valuation and inflation are different. That should not make investors comfortable. There has been talk about the perfect storm for some time but with equities at new highs and bonds still underneath historical levels, the chance of the perfect storm occurring is more likely.

The perfect storm is based on two premises, central banks have engineered an increase in equity markets to create a wealth effect and central banks want to have higher inflation. The first premise is related to the idea that the Fed is willing to accept bubbles in their efforts to stimulate aggregate demand. The second premise is based on the idea that the economy cannot go into a deflation or low inflation scenario and that growth will be enhanced if there was more inflation. 

If you got the central pulling for the perfect storm, it is more likely to occur. Central bankers believe they can control the storm before it gets out of control.

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