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It's back-to-basics time

Allow me to repeat part of what I wrote in my October editorial (web membership required to access full article, sign up here):

The past two years we've been dealing with [a recession], and some seasoned observers fear the worst is far from over. They advise avoiding the stock market and building your cash stockpile. Another group believes it's likely the economy has turned the corner and the market is looking forward to a recovery. These advisers recommend moving money off the sidelines out of cash and into stocks.

There's also a third group, which is a little harder to pin down as they vary in their expectations regarding economic recovery. What unites them is their expectation that the federal government's record-breaking deficits will increasingly cast doubt as to the soundness of the U.S. dollar and its value will decrease at an ever-quickening pace. In other words, they fear that sooner or later, we'll see much higher inflation.

Even if this third group is correct, the timing is uncertain. Thus, we have a situation where it can make perfect sense to believe in either scenario #1 or #2, and at the same time also believe in scenario #3. One can be concerned about deflation in the short-term, but also be concerned about inflation coming further down the road.

This is increasingly on our minds as Mark and I think through our suggested portfolio allocations for 2010. We want to offer inflation-hedge type investment options for our readers, yet do so in a way that doesn't over-emphasize them or imply that they're essential portfolio components quite yet.

At the individual level, as readers contemplate their current stock/bond mix and whether it still makes sense given the current environment, they must continue to balance their fear of loss (perhaps heightened after the recent bear market) and their need for growth (also heightened as a result of losses in 2008).

Daniel Fisher in Forbes recently highlighted the challenges facing investors next year:

In all of 2007 the Treasury issued $237 billion in new debt (net of retirements). This year, through early October alone, it has added $1.2 trillion to its obligations. That's $4 billion a day.

With a supply like that, logic would have it that prices would fall and yields rise. Instead, since approaching 4% in June, the yield on ten-year Treasurys has fallen steadily. On Oct. 7 a big chunk of the latest offering flowed through RBS at a yield of 3.2%, down from 3.5% a few weeks earlier....

What gives? Despite worries that the government's huge deficit will cause inflation and interest rates to spike, the bond market is signaling that we have a worse problem on our hands: a dismal economy.

Low interest rates aren't particularly good for investors... With few attractive alternatives, investors are squirreling away savings in Treasurys, which is pushing prices up and yields down.... "It's a strategy for losing money safely," says Erik Davidson, senior managing director at Wells Fargo's Private Bank, which is urging clients to move money into stocks.

Perhaps investors are not fools, though. Their willingness to buy Treasurys at crummy yields rather than stocks implies the economy will shrink next year rather than grow. Despite signs of a bottoming, industrial output is at 70% of capacity, the lowest level in two decades and ten percentage points below its 36-year average. Consumer credit outstanding, at $2.5 trillion, was off 6.5% in September from a year earlier and has now contracted for the longest period since the early 1990s. Unemployment is still going up.

The unwinding of the credit bubble is not over. U.S. banks have barely begun to digest their commercial real estate problems. A bolus of $600 billion in commercial mortgage-backed securities issued between 2005 and 2007 is likely to begin defaulting in earnest next year. All this could mean more economic weakness and a double-dip recession. In that case stocks are no bargain now.

Since none of us knows what 2010 holds for the economy or our investments, it's a good time to redouble our commitment to following biblical principles as we make money management decisions — get (and stay) debt free, build a contingency fund for the unexpected, and diversify our portfolios across a range of investments that march to different drummers.

Next year is shaping up as a time for caution, not investing heroics.

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