Ready Your Portfolio for the 2011 Stock Market

Oct.13.10 | About: SPDR Dow (DIA)

[Excerpted from Barker Financial Management's October Smarter Investing Newsletter]

The DJI closed at 10,788 in September returning 8% for the month. This was the best September for the index since 1939. Historically, a strong September is a prelude to a good 4th quarter, but remember that the U.S. economy is still finding its legs, the unemployment rate is still near 10%, and the foreclosure debacle could slow things down even further.

Unemployment is a self perpetuating cycle as companies will continue to run lean as they know there is a large pool of cheap labor that they can tap when they need it. Expect to see greater capital spending 4Q10 and hiring to pick up 3Q11. Larger market gains will be stymied by people taking profits and closing out losing positions to offset capital gains. My Prediction: DJI 10,900 at year’s end.

While no one can predict what the U.S. Stock Market will do in 2011, we can look at some of the major forces that will drive the market next year and extrapolate a reasonable outcome that can form the basis of a fundamental investment strategy to grow and protect your investment or retirement portfolio.

The U.S. is still the world’s largest economic engine and, pending a serious global confrontation, the real estate market, unemployment, and inflation will dictate the performance of the stock market again next year.

The U.S. economy began a fragile recovery this year after being hammered by the collapse of the real estate bubble and is still acting like a 40 year old prize fighter trying to keep his feet with three rounds to go.

Savvy investors, like the fighter, will take a defensive position to avoid a knockout so that they can come back to fight another day.So what do we do?

We know that it will take years to work off all of the foreclosed homes and short sales created when the housing bubble collapsed and that recent problems with the MERS system will slow this process even further.

Ready Your Portfolio for the 2011 Stock Market

We know that unemployment will continue to run 9% or more until the unemployed and underemployed find full time jobs, and we know that it is likely that the Federal Reserve will further stimulate the economy by buying Treasury bonds to lower interest rates and offset the deflationary effects of the shrinking demand for goods and services in the U.S.

Although targeting the sweet spot on the inflation rate may be a good thing, the economic value of lowering interest rates may be less effective, only because interest rates are so low already. If you are not buying a car, a big screen TV, or a house when you can borrow money at 2% to 4%, then lowering interest rates further is unlikely to get you in the showroom or on the phone to your real estate agent.

The real incentive to buy is when everyone that wants a job has one, and those that have jobs stop worrying that they will lose it. Creating enough jobs to backstop the recovery will take years, however, because some of these job losses are structural, and because businesses will hoard cash until it is clear that there is a sustainable and increased demand for their products and services.

Businesses will also work their current workforce overtime until demand outstrips capacity to the point that they will have to hire more people. All of this points to slow and uneven economic growth and a moribund stock market next year. Consequently, it is unlikely that you will earn better returns by taking more risk in the stock market, so pursuing a defensive strategy while looking for the occasional tactical opening to enhance your returns appears to be the smarter choice.

A defensive portfolio may hold some solid dividend paying stocks, a bond ladder and not bond funds with one exception being a TIPS fund in case the Fed overreaches with their accommodative monetary policy, 3 to 5 years worth of cash, and an emerging market stock and bond funds or ETFs because many of these countries now have stronger economies than our own.

Stay away from any developing country that has an unstable political system and keep in mind that some emerging markets may be overheated, creating an investment opportunity in developed countries that were oversold during the debt crisis.