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Today's Commentary: 06.06.06
The Demise of Diversity

Financial writers have made numerous attempts to clearly define the word diversity. It can mean so many things at once, that an exact definition is often elusive.

In the world of finances, when it comes to the subject of diversity, we all seem to hinge on the same thing: own a wide variety of holdings so as to alleviate the chances of all markets falling at the same time. This advice is becoming increasingly harder to follow as US and global markets have increasingly reacted the same way at the same time.

Markets have evolved, mutated if you will into a different creature altogether. And with it, the lines of diversification that investors have often sought have blurred to the point of being almost unrecognizable.

For years now, the word globalization has been tossed around like some cure-all for all economic ills. While shareholders and employees see the subject from entirely different perspectives, they are slowly aligning themselves to the fact the problem belongs to both groups equally. I have on numerous occasions referred to it as a rebalancing, much the way water seeks a certain height depending on the container.

That container is important. Each time an emerging economy comes on line, it offers a supply that the world needs. Often emerging nations are commodity rich with underdeveloped industries. No matter what you sell, the old adage goes, you need buyers. Among the best buyers for these emerging economies are the citizens of the U.S.

Often the United States involvement in the purchasing chain is secondary, buying raw materials only after they have been partially refined or manufactured. It is the dollar that keeps the wheels greased and so far has been the primary form of payment sought by these emerging countries.

So as economies seek to sell and we are eager to buy, the companies that are involved in this chain have become distinctly international. As one fills the container we siphon it off. To do that, we borrow. This keeps the container consistently replenished. Well-developed economies that regulate their growth through the availability of cash provide an ever-expanding trough.

Globalization is evolving very rapidly. What was once a very deep pool with few swimmers has now turned into a very shallow pool with many occupants. We are no longer the fat man in the bathtub.

So why are we surprised when equities react in lockstep across global exchanges? Why do the major banks of the world all seem coordinated, each acting in blind unison while keeping their individual country's investors on edge as if somehow they are acting separately? The world that Ben Bernanke inherited no longer resembles the old world where the United States held full economic sway. We are still the customer of choice but for how long?

By no means does this growing lack of diversity signal any sort of death knell for the US investor. It just limits your options and singles out the one strategy that might just work.

When I discuss diversity with new investors as do in my next book, I stick to a predetermined set of rules: leave the speculation to the speculators, index wherever possible, and keep that money coming in to those investments at a steady rate. That's right, the oldest standby of them all, dollar cost averaging.

Iım not so sure that each thread of economic data is as important as we all seem to think, at least when we place our money on a stock. Iım not even so sure that inflation has much of a near-term effect anymore. The corrosive power inflation has an effect on the future worth of your investments. But it has become something that is increasingly easier to predict. Day-to-day movements of data offer little help in determining a stock's long-term direction.

So the world is moving at almost the same pace seemingly headed for the same destination. We have become the experiment. Most of the world now recognizes that following the United Statesı lead on the issue of debt and deficits will allow other countries the time to examine and assess the theory of borrowing with abandon. The two primary questions these foreign bankers and investors ask themselves: Can an economy that borrows like the US does open the door to a descent into banana republic status and can they do so without taking the rest of the big economies with it? Or does it mean that debt has little value?

Back to investors, who have been mostly unaware of how we all became so intertwined economically. We sometimes act like protectionists yet we applaud every effort companies make to grow leaner here at home and while becoming better staffed abroad. We no longer fear outsourcing.

What we fear is lack of performance, loss of profitability and the inability of the markets to move ever upward. This is quite normal. Yet, I believe that the lion's share of investors are still commanded by daily dalliances of data.

Bernanke is and so are his governors. Wall Street wants a pause in the short-term interest rate hikes. Because they know that if the Fed chairman goes just little too far in the wrong direction, the rest of the established economies of the world will be forced to follow or risk overheating. What we do will determine what the world does ­ or not. We are the economic pioneers and not necessarily the leaders.

So diversity, from a purely technical standpoint, one that is entrenched in the notion that you can be at the right place most of the time, demands that your portfolio will need to be readjusted. Old school diversity involves making sure that you invest broadly across numerous sectors so as to protect your investments. How does one do that in this type of global economy?

If small caps move in tandem to large caps and large caps move in alignment with overseas equities, how do you diversify? We all cheer when the markets ascend in lockstep but will they all move down in unison as well?

We now know the answer to that question. If it remains yes, how can diversity save you?

If you have bought a basket of stocks that you believe have good fundamentals, keep them. If you have faith that your mutual fund managers will also show the tenacity of will and the courage of conviction to stay put in the face of gloomy economic data, rest assured. If you have a basket of index funds spread across four or five sectors without overlap, relax. Let the markets fall as they may.

But keep investing. The best investors understand that there will be occasional rebalancing needed. World economies need to do it just like the stock market does. The Fed has gone two rates hike too far, but they always have from a historical perspective.

Inflation will peak in the nine to twelve months following the last rate hike and twelve months later, stocks will look suddenly attractive. Unless of course you took cover, grabbed your cash and headed for the sidelines. Timing this market will take long-term trial and error.

You can rest assured that several things will take place as a result. Commodities are still being driven by speculation so they have moved up with stocks. Stocks will fall first, followed by commodities. Once the end users replace the speculators, things will change. The prices paid for these raw materials will still be high but not poised to go higher each trading day.

Short-term debt namely in the high risk category and corporate issuance have also seen some very good days of late. That can't and won't last which does not bode well for investors. Long-term government bonds have been in negative territory over the last year, which, if I am reading the tea leaves correctly, doesnıt exude confidence.

But dollar cost averaging trumps all attempts to outwit this troublesome and soon-to-be bothersome rebalancing. Stocks will slip as will short term debt. Emerging markets will overshoot their estimates of natural wealth and find customers being more cautious with their speculative outlays. Lack of cash will remove the speculative nature of commodities investing adjusting the price to a more need based price and not speculation driven one. Wait and see will reign.

And you won't care. Because you will keep buying pieces of your investments at a measured pace, you will do just fine. There are only two options. If Iım wrong, the markets will toss aside debt and inflation worries, concerns about growing too fast, and overheated economies and you will keep making money hand over fist. If that is the case, dollar cost averaging will prevent you from buying into an ever-rising market. Because you are buying evenly, you wonıt be overexposing yourself.

If I'm right and the markets move down, you will be very well positioned when all is forgiven, the world has rebalanced itself and economies are more stabilized. This will be the buying opportunity. For those who dollar cost average, profitability is all but guaranteed. Just like the textbooks suggest.

Baptism by Fire

Congratulations are extended to the new Treasury Secretary Henry M. Paulson Jr. He'll do a good job if he is allowed to do what he needs to do. I'm not so sure that will happen though.

The problem John Snow and his predecessor, Paul O'Neill faced and were criticized for was their inability to "staying on message". They hadn't completely bought the president's version of the economy and were ousted because of it. Both men did a good job for the wrong administration. It will be fun to watch Mr. Paulson adjust.

We all know that the White House hopes he will be the next Robert Rubin. That would be great for the dollar but would not forestall the events unfolding as I described above. Both he and Mr. Bernanke will see the next two years as very tumultuous both locally and globally. I wish him luck.

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