“It’s hard to make predictions, especially about the future.” . . . Yogi Berra

 Classic quote and never more true than right now. Despite the proliferation of online real-time news, social media and smartphones, it is virtually impossible to make accurate predictions about the economy and the financial markets.

The third quarter of 2012 is a perfect example.  It ended with equity markets posting the best gains in 3 years, in contrast to economic data in the US indicating a slowdown, an ongoing sovereign debt problem in Europe and signs of a growth problem in China.  Part of what supported and fueled the rise in equities were the actions taken by global central banks during the quarter.  The central banks of three major developed economies (US, Europe and Japan) all committed to new and unlimited monetary accommodation.  Additionally, most emerging market countries (Brazil, China, India) initiated aggressive interest rate cuts.

Now that the central banks are “all in”, it’s up to the politicians to determine whether the global economy reaccelerates or lapses into recession in 2013.  Three critical fiscal issues need to be resolved to determine which direction we go:

1.       The US election and resolution of the “fiscal cliff”

2.       Specific conditions imposed on individual countries in Europe in exchange for ECB (European Central Bank) support

3.       Additional stimulus initiatives in China

If politicians in all three economies (US, Europe, China) deliver hoped for policy responses, the global economy could reaccelerate in 2013 and equity markets could post another year of double-digit returns.  If the politicians deliver on 2 out of 3 needed responses, the global economy will likely stay out of recession but with only below trend growth.  If, unlike global central bankers, the politicians fail to understand the gravity of the economic risks and are unwilling to compromise on appropriate policy responses, then the global economy could slump back into recession in 2013. (source:  Riverfront Investment Group)

In this final scenario, which I do not anticipate, aggressive monetary policies can only soften the severity of the slump and the associated market declines.

From an investing point of view, I continue to be cautious but not defensive.  Where appropriate, I am making small increases to equity positions and adding non-correlated dividend paying investments to portfolios.  I am doing this because of three trends:

I.            Individual investors are not supporting equities – as evidenced by continuing outflows from equity mutual funds into bond (fixed income) mutual funds.

II.            Hedge fund managers are also not jumping into equities – as evidenced by the chart below.

III.            There is still a huge amount of cash sitting in money market accounts and CDs which are paying almost no interest right now.

Source: International Strategy & Investment, Inc.

While I remain focused on protection of principal, I am equally focused on protection of the purchasing power of principal.  Low interest rates will be with us for the near term (1-3years) and while overall inflation is relatively low certain expenses (health care, education, energy and taxes) will continue to increase at higher levels.  The net effect is that too much emphasis on protecting a dollar today will mean that dollar is worth less tomorrow.  I am confident that a balance can be maintained between these 2 concerns via diversification and careful monitoring of risk/return potential.

I hope you find this narrative informative.  Please pass it along to anyone who you believe would benefit from it.

Although the information included in this report has been obtained from sources we believe to be reliable, its accuracy and completeness are not asserted. All opinions and estimates included in this report constitute the judgment of the financial advisor as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

 Investing involves risk and you may incur a profit or a loss. Diversification does not ensure a profit or ensure against a loss. There is no assurance that any investment strategy will be successful.  Past performance is no assurance of future results.