So far, the economic recovery is playing out the way most pundits said it would: as a maddeningly slow, uphill grind rather than a quick, snappy rebound. Unemployment remains stubbornly high, consistent with most forecasts that it would take several years for this figure to get back down to prerecession levels. And while recent economic data has been mostly positive, some folks are getting nervous as the bull market heads toward its two-year anniversary. To be sure, the stock market has come very far, very fast. There are a number of risks floating around, but three things in particular have the greatest potential to cut our recovery short.
1. Aggressive spending cuts at the state and federal level
To be clear, I am not saying that government spending should not be cut. Just the opposite; our current rate of spending and our burgeoning budget deficit are clearly not sustainable over the long-run. While everyone wants to protect the spending that benefits them directly, cuts will need to be made across the board.
But implementing these cuts will be a matter of tricky timing. Cut too much, too soon, and the economy will be plunged back into recession. A prudent approach would be to gradually phase in budget cuts over a period of several years. Despite heated rhetoric, the very worst thing politicians can do right now is to hack away at spending willy-nilly. Cutting too aggressively now will cause more problems than it will solve.
While time will tell exactly how the political wrangling in the states and on the federal level will play out, there is little doubt that cuts will have to be made in the coming years, straining economic growth and on consumer spending.
That's why I think financially stable large-cap companies are a solid bet right now. Small-cap names have led the recovery so far, but eventually that leadership will change, and larger firms will move into the lead. In more challenging growth environments, larger names should have an advantage; they are not as dependent on accessing the credit markets, and they already have well-established market share. So make sure you've got enough exposure to domestic large-cap names, including dividend payers. Low-cost exchange-traded funds such as Vanguard Total Stock Market ETF (NYSE: VTI) and SPDR S&P 500 ETF (NYSE: SPY) are a good choice.
I'm not alone in my assessment that high-quality blue chips will be the next market sweet spot. Famed manager Jeremy Grantham of GMO sees large-cap value stocks as being undervalued while smaller, more speculative stocks are overvalued in comparison. Grantham favors value-oriented names like Johnson & Johnson (NYSE: JNJ), Microsoft (Nasdaq: MSFT), and Coca-Cola (NYSE: KO). Given that each of these stocks currently sells at a P/E of less than 13 and all sport dividend yields well in excess of 2%, it's easy to see the attraction here. So make sure you've got some heavyweights like these in your portfolio.
2. Political or economic turmoil in other regions
In my opinion, there are three wild cards here that investors need to watch out for in the coming quarters. First, we should worry about the turmoil in the Middle East. Oil prices have already spiked in response to the unrest in Egypt and Libya and may be heading higher.
Secondly, while concerns over a spiraling debt crisis in certain heavily burdened European countries seem to have dissipated, the problems haven't gone away. Several debt-strapped nations in the eurozone still face crushing debt loads and have the potential to roil the area's economy if a default or restructuring occurs.
Lastly, while emerging markets have been superstar performers in recent years, I think there are some dangers there. Inflation is on the rise in several large developing nations, including China and Brazil, which could spell further problems should these nations' economies begin to overheat. A collapse would have tremendous implications around the globe.
While global investing is pretty much a no-brainer in today's interconnected world, it does not come without risks, as we've seen. While there is no way to successfully avoid all global blow-ups, the best way to manage risk here is to make sure you are fully diversified across the globe.
That means investing in funds or ETFs that have exposure to both developed and emerging markets, in multiple regions and countries, and to many sectors within each country. Stay away from single-country funds for now; the risks are just too great. One good, well-diversified fund in the developed market space is Scout International (UMBWX), which ranks in the top 10% of its peer group in the past 15 years. If you're an emerging-markets investor, Vanguard MSCI Emerging Markets (NYSE: VWO) is one of the best ETF options in the field.
3. Inflationary pressures
Although core inflation has remained remarkably subdued in recent years, there are signs that prices pressures are building. Oil prices have already touched $100 a barrel, and many other commodities, especially precious metals, are reaching new highs. Given historically low interest rates and the fact that the Fed will likely remain accommodative for too long rather than risk tightening too soon and derailing the economy, higher inflation down the road is a near certainty. While some level of inflation is good for the economy, if prices rise too fast, it could put a crimp on an already fragile recovery as people's purchasing power is diminished.
While inflation isn't necessarily a good thing for the stock market, stocks are still some of the best long-term inflation fighters around. In a time of rising prices, you need investments that can produce higher returns -- and that means stocks. So make sure you don't have a lot of money sitting on the sidelines in cash and bonds if you are on the younger side of life.
Of course, if you are in, or close to, retirement, you do need a major portion of your assets to be in bonds. If you fall into this group, be sure to add some inflation protection to your bond allocation. Inflation-protected securities should get some good representation in your portfolio, whether through a fund like Vanguard Inflation-Protected Securities (VIPSX) or an ETF such as iShares Barclays TIPS Bond ETF (NYSE: TIP).
While we're still on a solid path to recovery, significant risks remain. I don't recommend trying to time the market to avoid all of these potential roadblocks, but by picking the right investments and staying diversified, you can invest successfully even in uncertain times.
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