Volatility and Uncertainty Continue

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This has been mostly a business travel week, capped by a New York visit in time to witness the University of Arizona’s thrilling basketball win last night over St. John’s at Madison Square Garden. Tonight I’ll be able to see the tournament championship game against Mississippi State before heading back to Tucson. Go Cats!

This week the stock market repeated the past few months’ pattern, characterized by tremendous daily price volatility. In fact, triple-digit daily moves in the Dow Jones Industrial Average have become the norm, not the exception. The week closed with the S&P 500 down by nearly 4%.

Both stocks and bonds bounced back and forth with each new headline about European or U.S. debt crises. As we have noted previously in these posts, current markets are responding to rumors, hopes and speculation far more than to investment-worthy data. With stock trading volume low and volatility high, it is apparent than the indexes are in the hands of hedge funds and high-frequency traders rather than true investors.

As has been the case for months, European bankers and heads of state are long on plan announcements and short on committed cash. It’s apparently far easier to pledge than to pay.

As its first deadline nears, the congressional supercommittee is increasingly in the news. The committee’s bipartisan recommendation and the subsequent congressional vote are due next week. Most political analysts believe there to be substantial risk of failure to agree on even the minimal $1.2 trillion deficit reduction over ten years. It’s impossible to know how investors will react to various degrees of success or failure to agree on the mandated reductions. Nonetheless, based on recent market performance, it is highly likely that reactions will be violent in one direction or another–or both.

Realistically, the debt problems in many European countries and the United States cannot be solved, only deferred. At present, deferral is all that investors are hoping for. It is impossible to forecast when the intractability of the debt condition will force itself upon investor consciousness. The only realistic alternatives in the long run are partial default or inflating away the problems by money creation. Which of the alternatives unfolds over time will subsequently induce bond market reactions that are polar opposites. The threat of default would penalize any suspect bonds but induce a flight to safety into perceived “safe haven” paper. The prospect of inflation could decimate bonds of all credit quality levels.

Equities could experience virtually opposite reactions. The threat of any consequential level of default would likely lead to severe economic contraction and a resultant stock market decline. Moderate inflation for an extended period of time might be beneficial for equities. On the other hand, rampant inflation would introduce huge economic uncertainty. Some companies would benefit; others would suffer. Historically, periods of powerful inflation have generally produced weak stock markets. Ironically, returns on short-term cash have outperformed stocks in periods of severe inflation.

Such uncertainty reinforces the advice we have given for well more than a decade: investors will be better served by maintaining a flexible asset allocation rather than the traditional fixed allocation with periodic rebalancing. The worst of all worlds for the fixed allocation approach would be a declining stock market induced by rampant inflation, which in turn produces negative bond returns – certainly a realistic possibility.