How to Play It: The New Normal

Posted on September 24, 2009

Every decade or so, investors are told to heed a new megatrend, whose chief appeal is, well, its newness. In the ’90s, investors were sold on the notion of a New Economy that wasn’t subject to the old laws of gravity and, among other things, could support higher stock valuations. And one of the best-selling investing books of the past decade was The New Investment Superstars, a tome that canonized a new breed of fund wizards, some of whom later proved to be mortal. Now comes the latest investment fad, the “new normal,” the idea championed by Pimco bond guru Bill Gross that the U.S. has entered a period of diminished expectations that requires investors to rethink their long love affair with stocks.

There’s a certain Biblical undertone to the new normal orthodoxy: After decades during which consumers lived beyond their means, the nation must now endure a long stretch of lean years during which consumers pay down debt. In the minds of Gross and Pimco colleague Mohamed El-Erian, the prospect of a period of no growth means investors should hold as little as 30% in stocks, vs. the 60% long deemed the proper mix. They also recommend holding more fixed-income assets like bonds and bank loans, as well as commodities.

The risk for investors is that the new normal proves to be merely the latest investment fad, and by moving into bonds they miss future rebounds in stocks. “The new normal is just a different way of saying ‘It’s different this time,’ and that’s often a recipe for disaster,” argues Barry Ritholtz, chief executive officer of Fusion IQ, a quantitative research firm. “The mathematician in me says we’re just reverting to the mean.” Ritholtz believes the U.S. will recover, but it may need years to work off its 25-year debt binge. He sees “a lot of parallels” between now and the 1973-74 recession, a downturn he says that serves as a good composite of the 19 previous bear markets. Then and now, the market fell more than 45%, then rebounded 60% to 70% (chart). If past is prologue, Ritholtz thinks there could be another leg down, a few years of treading water—and a powerful bull market starting around 2012 or 2013.

Ritholtz and other pros believe the best strategy for many investors may be to beef up stakes in fixed-income and alternative assets but maintain enough exposure to stocks to profit from the rally the “old normal” crowd believes is inevitable. Robert Arnott, head of Research Affiliates, a research and analytics firm in Newport Beach, Calif., thinks investors would do well to build a portfolio split into five even baskets: U.S. stocks paying healthy dividends, stocks and bonds from mature foreign economies, stocks and bonds from emerging markets, stocks and bonds built around oil and other commodities, and 20% in bonds, including Treasury inflation-protected securities, which pay a return based on inflation. He suggests owning some “assets that other investors are afraid of” in each basket, such as high-yield bonds.

Arnott’s approach gives investors a roughly 50% weighting in stocks, but that comes from economies that could grow faster than the U.S. And it incorporates exposure to commodities that should fare well in any rebound—and provide a hedge against a surge in inflation. It’s a portfolio that could produce the best of both worlds: a blend of assets that generates income during lean times but provides upside if the new normal isn’t so new after all.

IF THE PAST IS PROLOGUE...
Analyst Barry Ritholtz sees parallels between today and the 1973-74 recession, which he says argue for a powerful rebound around 2012.