Too Many Questions, Not Enough Answers

The bull market is now two years old and individual investors have finally decided it's safe to re-enter the stock market after missing most, if not all, of the rebound from the recession low of March 2009. Is that a bad sign or will future mutual fund inflows power the bull higher?

Quantitative easing has raised inflation expectations and produced an asset reallocation out of safe bonds and into riskier assets. Commodities, stocks and high yield bonds have benefitted by the flight from quality. Is this a sign of rising optimism about the economic recovery or a forced embrace of risk that will reverse at the first sign of economic weakness? What happens when QE comes to an end in June?

The budget debate is bogged down over a mere $60 billion in spending cuts, a rounding error for a deficit of $1.6 trillion. Can we cut the deficit without killing the economy? Will addressing the deficit increase confidence and encourage private sector job creation? Will there be real, substantive tax reform in addition to deficit reduction? Will tax reform be pro growth or just an excuse to raise taxes? Will the debate just be used to position for the next election?

China's latest five-year plan aims to rebalance their economy toward more domestic consumption. Accomplishing that goal will undoubtedly mean slower growth. What are the implications for the global economy? Will rebalancing the Chinese economy be a case of be careful what you wish for, you might get it?

If China's economy slows what will that mean for the other emerging markets dependent on that growth? What happens to commodity prices and the economies - such as Australia, Chile, Brazil, Peru and Canada just to mention a few - that are dependent on high natural resource prices for growth?

China and other emerging markets are trying to head off an incipient inflation problem while also trying to prevent rapid currency appreciation. Will they succeed? Will tighter monetary policy in emerging markets slow their economies? How much? Will they be able to engineer soft landings? Or will they go too far and crash their booming economies? How much will an emerging market slowdown affect developed world growth?

Is the European debt crisis over? Will Ireland renege on the debt deal negotiated by the previous government? Will Greece default? Is Portugal next to face an EU imposed bailout plan? Spain? Will the EU have a tea party moment as its citizens tire of bailing out the profligate members of the union? Are European banks in even worse shape than we think and will they have to take significant haircuts on the bonds they hold? How would that affect US banks?

Unrest in the Middle East has raised oil prices to over $100 per barrel. Will Saudi Arabia and other large oil producers experience similar turmoil? How high can oil prices rise before the US economy is pushed back into recession?

The economic statistics have been trending better. Jobless claims are under 400k and falling. The unemployment rate is finally falling. The ISM surveys are near all time highs. The yield curve is as steep as it has ever been. Credit spreads are narrow. Corporate profit margins are near all time highs. Stocks are not dramatically overvalued but they are quite dear if the economy slows or profit margins fall. Is all the good news merely an illusion created by government spending and easy Fed policy? Can I trust this recovery?

Investing always involves a degree of uncertainty. The intellectual gauntlet facing investors today, however, is more daunting than usual. Those who missed the rise in asset prices over the last two years face a difficult decision. Do you embrace risk once again as other individuals are doing despite that long list of concerns? Or do you stay parked in cash knowing it is a losing proposition once taxes and inflation are factored in? Do you stay in bonds and hope inflation doesn't become a problem? For those who were lucky or good enough to catch the reflation wave, the decision may be even more difficult. Will these problems be overcome as easily as the ones that existed two years ago? Have those original problems really been resolved? Do you stay in or take some chips off the table?

I chose the latter course. I started selling in client accounts late last year and continued through the first quarter. I sold Thailand, Turkey, Peru, Colombia and reduced exposure to Brazil and Chile. I sold Australia. I sold some high yield and high-grade corporate bonds. I reduced exposure to large cap US stocks. I've sold some selected individual stock positions. We are now sitting on a 20 - 25% cash cushion. I'm not entirely comfortable with it but the uncertainty at this point is too high and the risk/reward ratio seems highly unfavorable. For now, I am maintaining our allocation to gold, commodities and REITs.

My biggest concern is the US Dollar. Those who believe we can devalue our way to recovery - I'm talking to you Bernanke - are sorely mistaken. A falling dollar is a real world market indicator that US economic policy is seriously off track. The few abrupt and short lived rally attempts of the last two years were nothing more than brief flights to liquidity that quickly evaporated when the crises faded from the front pages. I shouldn't be so hard on Bernanke; he is only trying to fulfill the Fed's impossible dual mandate. Unfortunately, full employment cannot be conjured from the printing press and that's all he's got to work with.

The US desperately needs to improve the fiscal side of the equation to take some pressure off the Fed, other economies and especially the dollar. Government spending cuts and pro growth tax reform would encourage investment and strengthen the dollar. A stronger dollar would reduce investors' appetite for inflation hedges, reduce commodity prices and attract foreign capital. That in turn would reduce inflationary pressures in emerging markets while reducing the need for capital controls and tighter monetary policies. A lower value for the Euro would relieve some of the pressure on the periphery of Europe. The list of potential pitfalls above is not, unfortunately, a full accounting. Japan has serious budget issues and our own state and local governments face significant difficulties just to briefly mention two others. But better US economic policy would go a long way toward relieving many of the problems facing the global economy. If we don't get it soon, I fear the fall of the dollar could turn into a rout. And if that happens, even cash won't provide comfort.