More bull ahead or is the rally ending?

The following is an edited transcript of a webcast, “Forecast 2010,” that was held Dec. 8. InvestmentNews deputy editor Evan Cooper and senior editor Jeff Benjamin were the moderators. The panelists were Timothy Clift, chief investment officer at FundQuest Inc.; David Kelly, managing director and chief market strategist at J.P. Morgan Funds; and Jeffrey Knight, head of Putnam Global Asset Allocations.
InvestmentNews: We will start by just going around the room and asking each of our panelists for a little overview of where they see 2010 going — up, down or sideways.

Mr. Clift: The current equity bull market looks tired, so I think 2010 is going to be a fairly challenging environment. We really are going to need some new catalyst to move forward as many of the existing ones are expiring or being scaled back. The rally so far has been driven by excessive liquidity and low rates, and this can’t last forever. It is possible that the good job numbers in November [the unemployment rate fell to 10%, from 10.2% in October] were a game changer, but they also could just be a head fake and that they reflected holiday-season temporary hiring. So for unemployment numbers to change, we’re going to have to see more than this little blip on the screen.

We expect unemployment to be high all year. It is really not going to start coming down until 2011, but I think the bond markets are going to be challenged next. The equity markets also. I think we’ve got to start looking globally.

Mr. Kelly: The first thing to realize is that we have embarked upon a recovery, but we are a long way from normal. I think the recovery trade is the most important probable outcome here. It looks a little bit like 1982 from an economic perspective. Unemployment, I think, is close to a peak. I don’t think 10.2% was the peak; I think we will peak in the next few months. We’ve got a lot of indicators suggesting that unemployment is about to turn here, but I think really the major thing people need to realize is, this is the aftermath of a very big recession. And when you have a big recession, you tend to see a fairly sharp bounce-back in output over the first year or two thereafter.

We don’t think it is going as sharp this time around, but we still think we can do about 3.5% to 4% growth in 2010. That should be enough to produce some jobs. It certainly should be enough to produce some profit growth. So overall, although there are plenty of risks out there, we think the economy will gradually recover and pull itself together. And that should push stock prices higher. It should push Treasury rates higher. We also, of course, see plenty of opportunity in the rest of world, which we think will continue to outpace the United States.

Mr. Knight: If you think back to the beginning of “09, and you as an investor had the choice between cash, which was no-risk, no-return, and anything else, which had high volatility but high potential reward. So it was very hard to put a toe in the water. You had to jump all-in with almost anything you bought, but the motivation to do so was reasonably compelling.

At this point, you still have cash, offering zero return, but volatility has come down so dramatically across so many assets that the palette of choices seems to be much more continuous.

You can actually put a toe in the water, and some of the investments that have traditionally been lower-risk, lower-volatility seem positioned to behave that way again. But the stuff further out the risk curve remains more attractive.

So whether we’re talking about the credit markets, where many spreads — particularly in some of the more esoteric categories — are very, very wide or whether it is some of the traditionally more aggressive areas of stock markets like emerging markets, or whether it is just stocks versus something like Treasuries, I think along that spectrum, the emphasis is still on the more aggressive side.

The challenge is how to calibrate those investments, because we’ve seen a strong correlation across nearly every category of financial asset. Everybody was very focused on that at the end of 2008 because all of that was in a downward direction, but that really hasn’t changed. The consternation was a little bit lower in 2009 because everything is going up, but the correlations are still as problematic. So the challenge for investors is how to target attractive returns, but to do it with some balance and sensitivity to risk management.

InvestmentNews: Could you comment on Federal Reserve Chairman Ben Bernanke’s comments regarding a perhaps slower-than-normal economic recovery?

Mr. Kelly: We actually do see it as being a slower-than-normal recovery. In the first year of the average recovery in the last 50 years, GDP growth has been 5% and in fact, after the first — the two big recessions of the 50 years, which are the recessions of “82 and “75 — grew to a 7%. Now, we don’t see 7% growth or 5% over the next year. We’ll be very happy if we do 4%.

And I think Bernanke is sort of seeing the same thing: that this is a sluggish recovery for a recession this bad. And we think it could take all of five years to get the unemployment rate back down to normal levels. I think that’s part of what’s going on. But the other message that’s coming from the Federal Reserve is that they realize the threat of a double dip into recession — and deflation because of it — is much greater than the threat of inflation.

So I think the Fed is trying to send out a consistent message that they will not raise short-term interest rates anytime soon. On the market side, I agree with Jeff that investors are very skittish. I mean, psychologically, professional investors as much as amateur investors were absolutely kicked in the gut by what happened in the last two years. And that has made them very skittish.

So even if the recovery continues, we will truly be climbing a wall of worry the whole way, and that means we will have corrections along the way.

To Jeff’s point, the market is expected to gain roughly 60% in 2009 [from the March low through Dec. 31, the S&P 500 gained 64%]. The best drop that we’ve seen in any intermonth correction in this rally has been 7%. So for individual investors, I think it’s a very dangerous game trying to say, “OK, this is at the top now, so I’m going to sell out and get back into the bottom again.” These are small corrections in what has been a very strong rally.

InvestmentNews: A lot of people were excited when the unemployment rate dropped from 10.2% in October to 10% in November [the unemployment rate remained steady at 10% in December]. But it seems ridiculous to get all excited and call that such great news. What is normal for unemployment?

Mr. Kelly: It actually has changed a little bit. What economists mean by a normal level for unemployment is a level at which wage growth is fairly stable. And back in the 1970s, that was about a 6% unemployment rate because there was a lot churn in the labor markets. Right now, it is a number closer to 4% or 5%. So if you’re going to bring the unemployment down to about 5%, people would say, “OK, that’s full employment.” If you push it down below that, you’re going to have inflationary consequences.

But the main point is that there is actually a very consistent behavior of unemployment through the business cycle in the United States. It looks a little bit like a playground slide. It always goes up faster than it comes down. And on average, in recession, the unemployment rate goes up by 2% per year on the way up. It actually went up a little faster this time around. But it only comes down about 1% per year.

And the reason for that is, it’s much easier to destroy a job than create a job. So we will need to log 4% GDP growth year after year after year. If we do that — and we’ve done it before — then we will the push the unemployment rate down by 1 percentage point per year. But the problem is, if you start at 10%, it’ll take you five years to get down to 5%. But I do want to emphasize, there are a lot of indicators here suggesting that unemployment is going to begin to turn down.

We’ve seen an increase in temporary employment. We know that the index of leading economic indicators turned up 10 months ago, and that is a very good indicator that employment will turn positive within the year. We’ve seen huge increases in productivity. So a lot of workers are working very hard, but as profits go up, the productivity surges. That does tend to lead to some hiring. So we feel pretty confident that there is going to be some hiring over the next few months. It is just going to take a long time to get back to normal.

InvestmentNews: Give us a projection on where unemployment will peak, if you don’t think it has peaked already.

Mr. Kelly: The problem is right at the end [of a recession]. Unemployment always actually spikes. It always looks like a peak rather than a hill. And the reason it spikes is because right at the end, people hear things might be getting better, and they rush out to look for a job. The unemployment rate is measured as people actively looking for a job as a percentage of the labor force.

The labor force got to be very weak in the last few months, so I’m afraid that early in 2010, we’re suddenly going to see a sudden surge in the labor force. It’s going to push the unemployment rate up to 10.5%, 10.6% or 10.7% — that will be the peak — then maybe come down to 10.5%, 10.4%, 10.2%. I think by the summer, we’ll be below 10%, but I think we will still go higher before we go lower.

InvestmentNews: Tim, where do you see unemployment peaking? Is this something that you look for in your research?

Mr. Clift: We’re probably a little bit less optimistic than David. One of the big challenges we have coming in 2010 is the state budget deficits that we’re seeing — $50 billion in California. I don’t think any states are running in the black at this point. And I think that is going to add to the unemployment pressures next year. So you have to kind of think about the states. They’re unlike the [federal] government, which seems to be able to run a deficit as long as it wants. States really do need to come back and balance their budgets.

And they have only a few options. If they don’t [balance the budget], they default, and no state wants to do that, because they can’t issue any bonds after that. So they’re either going to raise taxes or cut services. So right now, raising taxes doesn’t seem like a good option. There is probably no one here that thinks federal taxes are going up anyway.

So their real main option is to cut services, and that’s generally workers. So we’re going to see some additional pressure on unemployment throughout most of 2010. So our expectation is that it is probably going to stay in that 10% range through the year.

InvestmentNews: Give us your take on interest rates. Could this economy sustain any kind of an increase?

Mr. Knight: Well, I think David characterized this very well; it is not just for the Fed a question of probabilities, but it is also a question of consequences. For an economy trying to work its way back from a debt bubble, the consequences of deflation are much more severe.

So the behavior is likely to err on the side of accommodation for a very long time, and I think until the Fed can really discern unmistakable recovery and economic momentum, they will choose not to pre-empt the seeds of the recovery as we see them now.

So by any conventional estimate of what the conditions would have to look like to get the Fed to make that first cut, we have a very hard time seeing that happening before even the fourth quarter of next year. So I think we can count on short-term rates’ staying low for a quite a long time.

The longer-term bond yields are a little harder to discern. There are two different ways that they might begin to rise, and maybe rise rapidly. One would be if market sentiment leads the Fed in recognizing a durable recovery and there begins to be a sense that the Fed is behind the curve and that inflation is around the corner, then we could see term premiums rise pretty dramatically.

On the other hand, if things aren’t getting better, there could be sovereign concerns, and I wouldn’t expect those to begin in the United States. We’ve certainly seen some sovereign concerns rippling around the world — a different pricing of government credit risk. So while I think we remain pretty benign on the likely path of interest rates at the short end, the long end is a lot less clear, and that may be one of the risky areas in markets in 2010.

InvestmentNews: David, what is your outlook for interest rates? At some point, there will be factors that force rates higher, correct?

Mr. Kelly: We see it exactly the same way as Jeff in terms of the short end. The only thing I would add is that the Federal Reserve is also really trying to recapitalize the banking system here.

One of the advantages of keeping short-term rates super low is that you generate a nice net interest margin, which pumps money back into a banking system still bleeding red ink — particularly from commercial real estate. So it needs all the cash it can get. That’s another motive for the Fed to keep short rates low.

What we have right now in one sense is a Treasury bubble. If you look at the real 10-year [Treasury inflation-protected securities] yield, it is about 1.3%. Historically, a 10-year real yield in the United States has been about 2.8%. So we’re at less than half the normal real yield that we’ve seen on 10-year paper from the government. Despite that, over the next decade, the debt-to-GDP ratio in this country will be over 70%, which is twice what it’s been on average over the last 40 years.

So at the moment, the U.S. government is proposing to issue twice as much debt as a share of the economy and pay half the real rates to do it. I don’t think this is sustainable in the long run. Over the next few years, I expect to see the Treasury interest rates move significantly higher at the long end.

InvestmentNews: David, can you share your view of the recent trend of the dollar? It might surprise some people.

Mr. Kelly: A lot of people don’t realize exactly what happened to the dollar over the last few years, because you only hear the bad news. The dollar went down, and then it went up, but nobody heard about it. In fact, what happened was, the dollar fell steadily from 2002 to 2008. And it hit a low on March 18, 2008, on a trade-weighted basis — that was the day after Bear Stearns [Cos. Inc.] went under. And so it was sort of marking the acceleration of the financial crisis in a way.

Then the dollar then up very sharply over the next year — over 20% on a trade-weighted basis — and it peaked on March 9, 2009, not by coincidence, the day the stock market hit its low. And since then, the dollar has fallen, but it is still higher today than it was the day Bear Stearns went under.

So we see this huge round trip on the dollar going up in 2008 and early 2009 as people got more scared, and coming down as people got more comfortable. What that tells you is that a lot of investors actually look at dollar-dominated assets as a safe haven. And when they feel more scared, they put money into dollar-denominated assets, and when they feel more comfortable, they invest in other areas, such as emerging markets.

Over the last few months, people have felt less scared, and so the dollar has been moving down. I don’t think that’s a bad thing; I think it is OK. So when the stock market gets jittery or falls, that’s almost a measure of global fears, and that is actually pushing people into the dollar. I think that’s why you’re seeing this weird inverse trade where if the stock market goes down, the dollar goes up, and vice versa.

InvestmentNews: Tim, what are your thoughts on the strength of the dollar? The dollar doesn’t have to move inversely with the stock market, does it?

Mr. Clift: Absolutely not. What we focus more on is the longer-term trends, and I think it is tough to play the currency game and try to figure out these kind of short-term movements, because they can work with markets or against them, and inversely. But we do think that the dollar is in a weakening trend and a multiple-year trend. It’s been a whole decade of this same idea, but we think over the next few years, we’re going to have the same issue. It’s not that there’s a concern for the dollar; it is the only currency that actually never defaulted over the last 200 years.

So it is still thought of as a safe haven and the strongest currency in the world. But because of the huge U.S. deficits — because of the fear that China, for example, is pulling out of Treasuries — it’s going to have this long-term pressure on the dollar. It’s not necessarily a bad thing for the stock markets. Nobody thinks that China is going yank all their money all at once, because their currency is tied to the dollar. We’re also their largest consumer; we buy the most of their exports. So it is not in their favor to try to pull that money out.

I just think that we’re going to see a devaluating or a decreasing of the dollar — over the next several years, anyway.

InvestmentNews: If the dollar may be on a decline in the long term, how does that affect your views of international investing and asset allocation for 2010? Should U.S. investors allocate more to foreign equities, for example?

Mr. Clift: That’s actually something we started doing back in March — increasing our allocation to global.

I think everybody gets somewhat nervous [when allocation to international assets increases]. Five or 10 years ago, people were afraid if you put 20% or 25% into non-U.S. [investments], and it’s because of this home-country bias that every country has: In France, 80% of the assets [are] in French equities.

But we had been allocating more and more, both on the equity side and on the fixed-income side, toward international. I would think that over time, we’re going to get closer to 40% or 50% in non-U.S. assets. We’re no longer 50% of the world global markets. We’re down in the 40% range, and that is constantly decreasing. To think that all the opportunities are left in the U.S. is probably naive. I think that over the long term, the larger growth rates are going to be outside the U.S.

InvestmentNews: Do you suggest hedging or directly investing in the foreign securities in the foreign currency?

Mr. Clift: Well, I think hedging is a tricky business, and I think if you have a long-term outlook and you want to have an opinion about the currencies, then you’re going to go unhedged. But for individual investors, there is this risk: You can have those markets do very well or poorly, but then it gets negated by a currency effect if you play it the wrong way.

So advisers may want to really think about whether they have an opinion about the currency and whether they want to go hedged or unhedged.

InvestmentNews: Jeffrey, tell us about your view on allocations to overseas stocks.

Mr. Knight: You need to think distinctively and coordinate your strategy when you allocate overseas between whether you like the markets themselves versus liking the currency, and we do think that if you’re against, a 50% hedge ratio is a better policy than unhedged. And interestingly, those trends tend to more than not reinforce one another.

In other words, a weaker dollar tends to go along with stronger markets overseas. And that hasn’t necessarily been the case this year. But I guess as we look forward, we would maybe be leaning a bit the other way. For one thing, the dollar movements have been accruing to U.S. global competitiveness and — particularly for some pretty big market-cap non-U.S. countries like Japan — away from the currency movements. And maybe I’d throw Europe into that bucket as well; the currency movements have been very tough for their export businesses.

Second, I think the longer-term case for dollar weakness is intact to a degree, but we might be transitioning toward an era of dollar stability as maybe even active intervention among the FIAT currencies [those whose value is unrelated to any physical quantity] tends to stabilize all of those cross-rates. So I think overweight international has been flattened by a weaker dollar, and I’m not sure that would be my go-to move for next year.

InvestmentNews: So you are saying not to overweight foreign securities?

Mr. Knight: I mean not as a broad category. Emerging markets are different in both dimensions. The fundamentals, the growth rates, the valuations and the potential for currency strength are much more attractive in emerging markets than in some of those developed markets I mentioned. So I just would be a little more granular in where we place our overweights and underweights.

InvestmentNews: David, give us your international view.

Mr. Kelly: I would be a little overweight. All of these bets need to be small bets. I think it’s very important for us to realize that you have to have a diversified portfolio. Look back at the last decades, and the number of things that happened that you never thought were going to get you, but got you. So I think people need to be diversified. I would have a small overweight international. First, because we do expect the dollar to continue to fall on a long-term basis, it is a very logical policy. We still have a significant current-account trade deficit, and to me, the interesting thing here is, every single year since 2000, the world has beaten the U.S. in terms of economic growth.

And the reason for that is because emerging and developing countries have become a bigger and bigger part of world economic activity. In fact, 60% of the GDP outside of the United States today is actually coming from what are classified as emerging or developing countries, if you compare them on a purchasing-power-priority basis.

So if the world is being dominated by these emerging markets and developing economies — and they’ve got these huge productivity growth rates unless something upsets the apple cart, I expect the U.S. to trail the world in economic growth for many years to come. And because of that, I would be a little overweight international overall to take advantage of stronger international growth. I agree that a lot of U.S. multinationals are taking advantage of emerging-markets growth. But in fact, our research suggests that foreign developed-country multinationals actually have even more exposure to emerging markets than U.S. ones do.

So you can play emerging markets at least as effectively through foreign developed-country companies as [through] U.S. companies. So yes, we’d have a smaller void there. The biggest overweight to look at very carefully is where you are in stocks, where you are in Treasuries. And I think people probably should look at being a little overweight in stocks and underweight in Treasuries, but we would have an overweight towards international.

InvestmentNews: We have many questions coming in from our attendees. What are a few of the sectors and maybe industries that you would look at over the next year, as places to take a long-term position.

Mr. Knight: I’ll start with energy as a sector. I think that is an interesting one. It has certainly been a darling sector of the past decade. It is one where a lot of portfolios have, either intentionally or unintentionally, gravitated to an overweight. But I think that is one that may be among the more problematic sectors because the scope for unanticipated profitability is much more demanding there.

If we look across all of the sectors so far this year and what has been a pretty impressive earnings recovery, the one sector that continues to disappoint, in terms of earnings growth and earnings surprise, is energy. That has become an underweight for us, and it’s been still performing OK, but on a year-to-date basis, it’s lagged the market, and over the course of the past month or so, we actually think the relative weakness of that sector is intensifying.

I am still concerned about the financial sector, particularly banks — particularly regional banks that have commercial-real-estate loans that are still being held on the balance sheet at par. We had a near-death experience across the financial sector, but many of those companies’ stock prices have come screaming back in celebration of their survival. But I think we are transitioning into more of a “show me the money and show me the profit model” world. I think there are some reasons to be a little bit skeptical there. I think we can extend that to a degree to diversified financials in general.

On the plus side, technology continues to come out near the top. It has been a very strong profit cycle. We think there is a pent-up demand for technology spending that has not yet materialized in a terribly forceful way, and these are companies that are generating free cash flow, that have lots of flexibility. We might see some M&A, etc. I think there is quite a strong case to be made for technology hardware, for software, etc.

I think there are areas within health care that remain attractive. There obviously are some public-policy risks there, but we think health care IT as a microsector is one that’s still attractive. And at this point in the cycle, we’re still inclined to maintain a more cyclical and less defensive profile, which would also steer us toward materials and away from things like utilities and staples.

InvestmentNews: Tim, can you take that question, looking at some specific categories?

Mr. Clift: I think we’re actually on the same wavelength here, with very similar ideas about the two we like the most being technology and health care. We think technology offers really good prospects; it’s a sector than can grow on its own and doesn’t rely heavily on consumers. And we know consumer spending is low right now versus other sectors like financials where you really need consumers to be part of that. Also, a lower-employment environment bodes well for technology, as companies need to increase their productivity. If they’re not hiring people; the way to do it is through technology.

On the health care side, we think this offers very good risk-adjusted-return prospects. The sector hasn’t participated a lot in this year’s rally. And it has left their valuations quite compressed, due to worry about the current health care reform initiatives.

But the bill is likely to end up being a compromise and once it’s passed, the uncertainty overhanging that sector will be cleared and I think there is a lot of upside potential there.

InvestmentNews: You guys are both bullish on health care, but there’s still a lot of uncertainty about the effect of the reform initiatives. How do those two work together? It doesn’t seem like they should.

Mr. Clift: I think there are certainly going to be winners and losers. I think the winners end up being the drug companies, because you have more people that are going to be issued prescriptions, and because there are more people that are going to be covered. Hospitals end up doing better, and pharmacies end up doing better.

Some insurance companies may be losers [if] they’re forced to insure just about everyone, the good and the bad. So you certainly have to pick through. But overall, the money that is going to be spent within the health care industry is going to be positive down the road.

InvestmentNews: David, can you talk about a few sectors and categories?

Mr. Kelly: To be honest, I think that Jeff and Tim have covered it very well. We have almost exactly the same views.

Mr. Clift: Uh-oh.

Mr. Kelly: Which scares me. But I think I can add a few things. We do have this public-policy question mark over health care, but my rather cynical reading of what’s going on is that the only way to get a bill passed is to give everybody a little bribe to do it. And so you end up with more health care spending rather than less.

I would also say that there is a very big public-policy question mark over the financial sector. On the positive side, I think the Federal Reserve is trying to funnel money back into financials through the back door through an easy-money policy. But on the negative side, the [Federal Deposit Insurance Corp.] needs money. And there are all sorts of ideas of taxes on transactions or regulations on derivatives, so I think there are a lot of questions about how the government might affect profitability in the financial sector.

So I think the easy play is just to play the cycle, to recognize that a global economic rebound first helps technology and, second, probably helps consumer cyclicals a little bit more than people realize. But I think that’s the safest play rather than trying to guess which way Washington is going to jump next.

InvestmentNews: You didn’t mention energy, but if you guys are all on the same page you must be bearish on energy, too. If you are, why?

Mr. Kelly: It is a fascinating sector. If you look at supply and demand, there’s no reason to be positive at all. We’ve got this recession, which truly was global, leaving a lot of unemployed resources around the world. In the short term, we are to some extent awash in oil, so it doesn’t look very positive at these prices. But there are two other things that are affecting this.

One of the things I worry about a lot is, the Iranians are building a bomb, and the Israelis really can’t afford for the Iranians to have a bomb. And something at some stage may trigger a war there. That could easily happen. I think that’s one thing to look at.

A second thing to look at is that a lot of people are using commodities as an investment play, as opposed to using commodities as part of the production of the economy. So this whole sector is being hijacked by speculators rather than fundamentalists. And I think that is feeding money into the commodities sector, which wouldn’t be justified by a period of a demand and supply for gold or copper or oil. I think there is a lot of speculation going on there. And that is actually pretty bullish, although dangerous, for all of those pieces because there is a huge amount of money still sitting in liquid assets. And vast liquidity comes off the sidelines and moves into long-term assets to the extent that it gets siphoned off into relatively small pockets such as commodities or gold. It can actually push those prices up much further than fundamentals would suggest.

InvestmentNews:
Jeffrey and Tim, what are you worried about? Economically, what keeps you up at night?

Mr. Clift: We are getting into a new global environment. Our world is now fundamentally interconnected, and we certainly saw that in the last recession that whatever happened in the U.S. spread dramatically throughout the world.

It’s starting to mark a significant shift in global geopolitics. For the last 20 years, since the collapse of communism, we’ve been the undisputed global superpower. But now, I think we’re witnessing an emergence of a multipolar system between the U.S. and China, and we’re going to see how big of a part [Europe is] going to play in this. I think it really does change the dynamics. We’re no longer an island that can try to withstand what’s going on elsewhere in the world. We’re really in the middle of it.

Is there a specific incident that’s going to happen that keeps me up at night? No, because you can never predict those types of things. But it becomes a lot more challenging because there are so many more interconnected pieces in the markets. Things can move much more rapidly, and collapses can happen much more suddenly than expected.

InvestmentNews: Jeffrey, what keeps you up at night?

Mr. Knight: If I reflect on where we are in this cycle of crisis, you could argue that what happened is not a deflationary collapse, but rather a very pronounced crisis in banking that we’re recovering from, kind of like the 1907 model, I suppose. And what matters, and what I think was reinforced and revealed to the world is, in a fractional-reserve banking system, how important confidence is and how quickly it can go away, and how dramatically that can affect the liquidity of anything that you own or trade.

What worries me is anything that can trigger a relapse of a crisis of confidence, because what was required to restore that confidence this time, there’s not the capacity to repeat that. The recovery, as David said, is very much on track, gathering momentum and has a lot of self-reinforcing attributes to it. I think David is also right that what the Fed, in particular, is up to is kind of a game of clock management where they’re trying to re-liquify things and rebuild capital bases before the next storm. So what I worry about is that from some unknown place, the new crisis emerges before that process has adequately replenished the resiliency of the system.

Mr. Kelly: And you’re lamenting the absence of a J.P. Morgan, who in 1907 just came in and said “OK, we’re going to stand behind things.”

Mr. Knight: J.P. Morgan figured it out, but ultimately, it was the corporate sector that really had the ultimate dry powder that finally plugged in all the gaps. This time, obviously, it was the public sector, which seems to be totally tapped out. And I don’t know — if we were forced into another kind of volatility storm with the characteristics of illiquidity and insolvency — where the confidence comes from to get past that.

Mr. Kelly: I agree with everything you said there, Jeff, but I think in terms of quantifying this risk, the problem isn’t just the economic dislocation — because, yes, we had a housing bubble which burst [in 2007], and we kind of all knew that was happening or going to happen — but then we end up with this massive global financial crisis.

What I think the general public doesn’t understand is how much of that crisis was due to a mountain of complexity and leverage that was built up among financial institutions. With the advent of credit default swaps, you multiply many, many times the assets they were actually supposed to be covering. The growth of various types of collateralized debt obligations, the speed of trading, all of these things meant that we almost created risk out of thin air.

One of the problems I see right now is that in Washington, there is a lot of baying about this thing all being about greed and about big banks being too big to fail, but if you think about it, you know, the banks that really caused the problem here, Lehman Brothers [Holdings Inc.] and [The] Bear Stearns [Cos. Inc.], those weren’t really very big corporations.

The problem was the interaction or the web of complexity with which they were tied to the entire world of global finance. I’m just wondering if we have built an edifice of complexity which makes the world more vulnerable to a small shock causing a big explosion, because you’ve got all those interlaced agreements. And so we may just have a more chaotic world because of what we have built here.

Mr. Knight: Just to jump in on that one too, what I think that results in is a practical challenge for investors. It creates this environment where all of the asset markets are much more strongly connected day to day and much harder to diversify.

That’s where I think — we talked about the dollar versus the stock market. Weak dollars have been good for the stock market, but it’s not just stock; it’s everything. You come in in the morning and look at your screens, dollar down, everything up or vice versa.

The challenge is that even if it’s a low-probability scenario, the conditions that caused what happened in 2008 haven’t really changed that much. And so we’ve got to think about ways to diversify and protect our portfolios differently than just spreading our money across fully invested market positions.

InvestmentNews:Though they may not understand fully the aforementioned complexity and interrelatedness, the clients — many of them older people — of the advisers listening in certainly feel the anxiety that this provokes. What should an adviser do for a client who is approaching retirement, given this kind of environment?

Mr. Knight: The current dominant template for diversification is to find four or six or 10 different ways to invest in a market, and combine them, and expect them all to behave differently.

So you might have a bond market investment, a stock market investment, an emerging-markets investment and a high-yield investment, but the underlining philosophy across all those investments is, “I want to be invested in the market.” And what I think is missing is a more dynamic and flexible category that may or may not be exposed to markets but that operates from a philosophy that’s more absolute-return-oriented and more responsive to: “What do I think is going to go up, and what do I think I’m going to make money on?” I think investors have to be cognizant of the fact that the template for investments was born in an unprecedented 20-year bull market where stocks in particular went up a lot. So the playbook of, “Get your market exposure and maybe combine six different kinds of market exposure,” came from, and got reinforced by, an unusual era in markets.

And I’m not saying that it’s wrong, but it is incomplete and that there ought to be room in a portfolio for strategies that are more flexible and less market-dependent. And there are lots of different versions of that. The key to me is to find things that you really believe can have resiliency — even in another volatility storm — that aren’t widely negative-carry [where the cost of borrowing to pay for the securities purchase is greater than the expected return]. So you can just buy a bunch of put options, but that might bankrupt you while you’re waiting for the black swan to fly by; the trick is to try to find something that can actually have a chance of keeping its resiliency that isn’t widely negative-carry.

Mr. Clift: One of the biggest questions we are getting in the last few months is, where do you get a little more conservative, from a retirement standpoint?

I’ve got clients wanting to be very conservative. They’re getting close to retirement. Money markets are paying them next to nothing. Next on the risk spectrum would be Treasuries, and I think we on this panel are agreeing that Treasuries are probably not a good place to be either. And there’s downside in there, so I think what a lot of advisers end up doing is either taking these bucket approaches or breaking assets into the essential versus the discretionary. And for the stuff that’s essential — they’ve got to pay the bills, they’ve got to pay the mortgage and their health insurance — you have to figure out a fixed-income-oriented product that has some yield, so you may end up being partially in global bonds.

You get a little bit more yield and still some diversification, but at least putting everything in somewhere that you’re going to have some less volatile assets for those essential needs. The bucket for the discretionary assets would be broken out into other asset classes that can generate returns and overcome inflation that’s going to occur down the road.

Mr. Kelly: I think people really ask themselves a deep question about how pessimistic or optimistic they’re really being here, because I haven’t met one financial adviser over the last six months who has told me that their clients are generally optimistic at this stage. I think that after what we’ve been through the last decade, and particularly last year, everybody is very negative.

So I think probably the biggest risk is that people are too conservative here. To me, one of the interesting things is that people have the sense of: The market failed, and it’s come back in a good way.

But in fact, if you look at it, the S&P 500 lost 888 points on the way down — from Oct. 9, 2007, to March 9, 2009. It’s gained 432 of those back as of this afternoon [Dec. 8]. So it has regained less than half of its bear market losses. And so I think people do need to think about not being underweight stocks. You have to worry about the possible, but I think you should still bet on the probable — and the probable is that the economy will continue to improve.

S&P 500 earnings will probably hit a new peak within the next three years.

And if that happens, the stock market will probably come back within the next five years to its level of October 2007. If it does, you get good returns there. So at some stage, people are going to have just keep their nerve. If you can afford to stay in very safe investments, by all means do it, but if you need your money to grow for you, then you do run some risks by being conservative, conservative and conservative, and waiting for the all-clear, because most likely, the economy will continue to improve.

I think the worst thing somebody could do is just wait until everybody feels comfortable to get back into long-term investments again.

InvestmentNews: What effect do you think regulatory reform will have on this market recovery?

Mr. Kelly: Both as a citizen and taxpayer, and as somebody who works in a major bank, I’m in favor of regulatory reform. I’m very worried that regulatory reform will be aimed in the wrong direction, because I don’t think the public understands what’s going on here. For example, I worry about the idea that people should be penalized because they made risky loans. And the truth is, the economy can’t grow at all unless somebody makes a risky loan. There’s nothing wrong with making risky loans. That’s what banks are supposed to do.

I also worry that attempts to force banks to have more and more capital, without having some way of getting that capital back into the banks, will force them to reduce their lending.

So if I felt that if Congress really had a clear understanding of the macroeconomic consequences of regulatory reform, I’d be all in favor of it. As it is, I’m rather nervous about it. There are lots of things that need to be reformed, but I’m nervous that government won’t actually fix the things that need to be fixed.

Mr. Knight: The general legislative direction towards higher taxes is likely to be a significant head wind for economic growth and, if misapplied, could really short-circuit the recovery, particularly in employment. On the broader question of regulation, that’s what I worry about.

On the more narrow question about the behavior within the financial system, I think the key is the compensation dimension. I think the motivation for reaping short-term rewards was far too compelling, and I think that’s a very hard thing to regulate. But I hope the institutions have learned the value of longer-term value creation compensation models as opposed to shorter-term transaction-motivated compensation models.

Mr. Clift: I think some regulation is certainly needed and probably could have helped in the past along the lines of better capital requirements and more transparency around the derivatives markets, for example.

I probably have similar concerns as the other panelists about what Congress is going actually enact and whether some of this ends up being a way to punish financial institutions rather than help them work better in a better environment.

Are they going to make sure their compensation regulations align properly to help make businesses grow or do they just want to have a public appearance of saying, “Nobody should make this much money”?

That’s the wrong attitude. So while we’re hopeful that they’re going to make the right decisions, we’ll see.

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