After a Lousy First Half, What's Next?

07/03/2008 12:00 am EST

Focus: MARKETS

Howard Gold

Founder & President, GoldenEgg Investing

T.S. Eliot got it wrong: June, not April, is the cruelest month—at least if you’re an investor. And July hasn’t gotten off to a great start, either.

So, what’s ahead? And what do we do now?

It’s a tough question after six miserable months.

June was about as bad as it gets. The Dow Jones Industrial Average lost 10%, its poorest monthly performance since September 2002 and its worst June since 1930. What a comparison! Globally, equities gave up an astonishing $3 trillion in market value in the month.

That capped an eminently forgettable first half. The Dow lost 14.4% in the first six months of 2008, the Standard & Poor’s 500 index fell 12.8%, and the Nasdaq Composite index was off 13.6%. Of these, only the S&P remains technically out of bear market range (a 20% decline from the peak), but not by much. It’s probably only a matter of time before we get there.

Overseas markets, with some exceptions, have done even worse. The MSCI world equity index slid 12% in the first half, and emerging markets have been a catastrophe. Last year’s superstars—India, China, and Asia except for Japan—have plummeted as higher oil prices and inflation put on the big squeeze.

And China may fall a lot further.

Commodities have been the only bright spot: Oil’s remarkable ascent to over $145 a barrel and sharp rallies in metals and grains have propelled that sector into the limelight for the first time in a generation.

This has all been frustrating, to say the least, for many leading investment gurus and the rest of us who try to make sense of what’s going on in the markets. Not since Jimmy Carter was in the White House have we had a combination of slow growth and sharply rising commodity prices, which usually signify an overheating economy. Throw in a global financial crisis and you have a once-in-a-lifetime “perfect storm.”

That makes devising a timely investment strategy all the more challenging. If you think we’re headed for a deeper financial crisis or recession, then buy bonds, preferably US Treasurys. If you think inflation will take off, buy commodities and inflation-protected securities, or TIPs. Paradoxically, all of those have done well at various times over the year’s first six months.

Right now, the big investment banks and financial institutions that created this whole mess remain shaky and will continue to post billions of dollars of losses and write-downs in the months ahead. Their stocks probably won’t recover for years. But I don’t expect another major institution to go under, a la Bear Stearns.

The US economy has been weakening steadily over the last few months, as employment continues to erode, housing remains in the doldrums, and higher oil prices act like a tax on consumption. I still don’t think we’re in a recession just yet, but growth will be weak the rest of this year and probably into 2009.

Ultimately, slowing demand here, in China, and in other emerging markets will cause a sharp correction in oil prices. And as the Federal Reserve moves to raise short-term interest rates late in the year, that could trigger a rally in the dollar and stocks.

Of course, there’s always uncertainty in markets—that’s how you make money. And perpetual handwringers invariably find something to worry about. But as I wrote in late February, there are contradictory forces in the markets now that make it especially hard to call. You need to prepare for several different scenarios, each of which could easily happen.

That’s why I came up with “Your Ideal Portfolio For Now”—a widely diversified handful of exchange traded funds that gives you good exposure to stocks while protecting you against any number of Bad Things. That approach helps smooth out the peaks and valleys, thereby reducing risk, which too many investors overlook.

In that February column I recommended investors put 30% in a broad US stock index ETF; 20% in an all-world index ETF; 10% in a large growth ETF (or in another category of your choosing); 20% in bonds; 10% in cash, and 10% in commodities.

Let’s see how it’s fared:

Clearly, the diversification and solid weighting in commodities helped save the day. The strong performance of the commodities ETF plus the decent return on cash and stability of the bond fund muted the horrible performance of stocks. Yes, the portfolio has lost some ground, but much less than stocks did.

Admittedly, had I been even heavier in commodities it would have done much better, but who knew? When commodities fall they’ll fall hard, just as emerging markets have done. So, unless you’re a very, very sophisticated trader or investor who knows exactly when to pull the trigger, the prudent course is to get some exposure to everything and tweak it as conditions change.

I’m going to do that now. I’m letting my commodities position run a bit, though it’s a little higher than my 10% target now. Meanwhile, stocks are much, much cheaper, so I’m taking a slightly more aggressive stance. I’m selling half my position in the large-growth ETF and putting into a mid-cap growth ETF, which I think will do best when stocks eventually rally.

So, let’s assign 5% of our portfolio (about $5,000 of the $100,000 we started with) to the iShares S&P MidCap 400 Growth index (NYSEArca: IJK). Morningstar gives it a four-star rating and says it is trading at about 10% below fair value. We’ll make more adjustments in the weeks ahead.

But for now, let’s all forget about stocks, gas prices, the election, whatever. Because although life has gotten a lot tougher for a lot of Americans, we still have a lot to be grateful for on the nation’s 232nd birthday. So, have a beer, have a barbecue, watch some fireworks—enjoy. On this holiday weekend, we all need a break.

Howard R. Gold is executive editor of MoneyShow.com. The opinions expressed here are his own and do not necessarily reflect the views of InterShow or MoneyShow.com.

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