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The stock market adage “sell in May and go away” is based on the historical tendency for stocks to generate most of their positive returns during the six-month period from November 1 through April 30. Since 1950, the Dow has appreciated 7.4% on average during this favorable period, versus only a 0.4% average return in the May 1 through October 31 interval. It is not difficult to imagine this seasonal pattern playing out again this year. The stock market was very strong in the favorable six month period just ended. The Dow gained 13% from November 1 through April 30. Looking out over the next six months, there are plenty of factors that could derail the bull market, including:

1. The end of Fed money printing (for now anyway). When the Federal Reserve completes its $600 billion debt monetization program at the end of June, it will no longer be injecting $75 billion per month of newly printed money into the financial system. To be sure, the Fed will not be tightening monetary policy by either restoring a positive interest rate or reducing it bloated $2.7 trillion balance sheet. Nonetheless, the end of so-called quantitative easing will undoubtedly test investor risk appetites and the powerful upside momentum of stocks since the program was announced.

2. Peaking leading economic indicators. The economy has positive momentum now, but unprecedented monetary and fiscal stimulus will begin to be withdrawn in the months ahead, and it remains to be seen how the economy will fare. The stock market leads the economy, and the U.S. economy in 2012 is very likely to be weaker than 2011, due in part to the expiration of stimulus enacted in late 2010 (i.e. reduced social security withholding and 100% depreciation on new capital investment).

3. Inflation pressures unlikely to be “transitory.” The Fed continues to obfuscate the inflation problem and is out on a limb relative to almost every major central bank in the world. Inflation pressures are much more likely to be “sticky” than “transitory.” Given that the U.S. average price of gasoline is $3.94 today versus $2.80 six months ago (a 40% increase), Americans know that the Fed’s story doesn’t add up. Although monetary policy remains extraordinarily loose in the U.S., most foreign central banks are tightening monetary conditions to confront obvious inflation pressures, which raises risks for assets tied to the global growth and reflation theme.

4. U.S. debt-ceiling turmoil and the recognition that we are entering the endgame of the debt issue. The country and its politicians are finally acknowledging the scope and urgency of our fiscal problem. There is a growing recognition of the necessity of an overhaul of the federal budget and entitlement programs, combined with increased federal tax revenue. There is no intellectual mystery involved in balancing the budget in a centrist fashion, but the political parties are intransigent and deeply entrenched. Unless the bipartisan “gang of six” in the U.S. Senate can save the day, the parties appear incapable of compromising around a plan for fiscal sustainability. This would be a tragic crisis of leadership. The issue for the markets is that we can’t take enough out of the debt without hurting the economy, but if we don’t act, we continue down the immoral path of mortgaging our economic future and debasing the dollar. Our fiscal situation is clearly unsustainable and dangerous, but for the time being we face neither an imminent collapse nor a probable solution, which creates a perplexing investment environment indeed.

5. U.S. Dollar in the danger zone. Given the “print and spend” policies of the U.S., it is not surprising that the U.S. dollar index is testing historic lows (See Exhibit 1). On the back of deeply negative “real” interest rates, in contrast to the tightening posture of most foreign central banks, the dollar has recently been depreciating at an increasingly rapid pace. Sentiment is very bearish against the US dollar, and the anti-dollar trade is crowded. Contrarian investing suggests that at least a temporary low in the USD should be close at hand, but given how dollar-bearish our policies are, and how the world is looking for ways to reduce USD exposure, I wouldn’t want to call a bottom. A break to new all-time lows in the USD has the potential to be very destabilizing to global financial markets.

Exhibit 1: Not a Pretty Picture

Given the above risks, and with stocks trading at or near bull market highs, it makes sense to trim risk in portfolios. Another reason to take a more cautious stance is the sentiment backdrop. Indicators of investor psychology suggest that optimism is becoming excessive. Examples include: (i) a three-to-one ratio of bulls-to-bears in the most recent report from Investors Intelligence, which tracks the opinion of investment newsletter writers; (ii) an 82% commitment to equities reflected in the latest investment manager survey conducted by the American Association of Investment Managers; (iii) a recent sub-15 reading in the CBOE Volatility Index (VIX), reflecting extreme complacency (see Exhibit 2); and (iv) over three-to-one bull-to-bear positioning among market-timing retail investors who use Rydex leveraged mutual funds (see Exhibit 3). When a bullish outlook is the opinion of the vast majority, it is usually a good time to lighten up on exposure to risk.

Exhibit 2: Lowest VIX Reading Since Start of Bull Market

Exhibit 3: Extreme Bullishness of Rydex Leveraged Mutual Fund Traders is a Contrarian Sell Signal

Today’s bull market is mature by historical standards, both in terms of duration and magnitude, and has quite possibly entered a phase where the remaining upside potential is smaller than the downside risk from whatever peak is reached. The current investment environment is one where no asset class looks attractively priced, and most look expensive with little margin of safety. The situation is made even more difficult by the dearth of safe assets offering reasonable returns while waiting for risky assets to become more attractively priced. This makes asset allocation decisions neither simple nor comfortable.

The principal cause of this investment dilemma is of course the Federal Reserve, which exercises far too much influence on financial markets and must eventually be reformed. The investment landscape today is excessively defined by a psychological battle between the Fed and investors. Investors rationally want to control their risk exposures, but any money held in short-term, dollar-denominated deposits runs the risk of being victimized by negative real interest rate and dollar debasement. One analyst I follow offered the wry metaphor that investors today are guinea pigs in some kind of Princeton Economics Department experiment! Prudent investors with an average tolerance for risk are naturally looking for a solution to this problem. With that in mind, I assembled the following fully invested ETF portfolio as one potential approach.

Stocks:

The stock market as a whole is overvalued on the basis of cyclically adjusted earnings, but not egregiously so. There are areas of the stock market that provide reasonable value. Moreover, the Fed “owns” the stock market like it has never owned it before, given that it has articulated a policy of stimulating and supporting stock prices. Fed policy will remain very loose, and it is reasonable to expect another round of quantitative easing the next time the stock market falls 15% or more. To protect purchasing power and achieve some real growth of capital, after inflation, investors need to maintain exposure to stocks. We think around 40% to 50% is appropriate at this point in time for a moderate risk asset allocation portfolio, allocated along the following lines.

10%-15% Vanguard Dividend Appreciation (NYSEARCA:VIG): VIG provides exposure to approximately 130 highquality U.S. stocks – large-cap companies with global franchises, solid balance sheets, and consistent earnings and dividends. VIG has a current dividend yield of 2.1%, net of fund expenses.

10%-15% WidomTree Large Cap Dividend (NYSEARCA:DLN): DLN provides exposure to the 300 largest dividend paying companies in the U.S. DLN is weighted by aggregate annual dividends paid rather than dividend yield, and has a current dividend yield of 2.7%, net of fund expenses

10% Vanguard FTSE All-World Ex-U.S. (NYSEARCA:VEU): VEU provides broad-based exposure to foreign stocks, which account for 60% of global stock market capitalization. VEU tracks an index of over 2,100 foreign stocks from over 40 countries in developed and emerging markets.

5% WisdomTree Japan Total Dividend (NYSEARCA:DXJ): DXJ tracks a dividend-weighted index of over 300 Japanese stocks. The fund hedges exposure to fluctuations between the value of the U.S. dollar and the Japanese yen. As a result, DXJ provides exposure to Japanese stocks but not the Japanese currency. Japanese stocks are among the most attractively valued in the world. The index underlying DXJ is valued at approximately one times book value (net assets). DXJ’s current dividend yield is 2.1%, net of fund expenses.

5% WisdomTree Emerging Markets Equity Income (NYSEARCA:DEM): DEM tracks a dividend-weighted index of approximately 270 companies from approximately 20 emerging markets. DEM’s dividend yield of approximately 4% (net of fund expenses) provides attractive exposure to emerging markets stocks.

Bonds:

It is exceedingly difficult to find anything attractively priced in the bond markets. In virtually every area of the investment grade bond market, yields are lower than duration, so investors are not getting paid to take interest rate risk. The consequence is that for most bond funds, the upside is strictly limited, and returns can be easily wiped out by as little as a one percent rise in interest rates. The objective from the following package of bond ETFs is to preserve capital on an inflation-adjusted basis, and have dry powder to deploy when better opportunities arise, either in the bond market or in other asset classes.

10% SPDR Barclays Capital Short Term Corporate Bond (NYSEARCA:SCPB): SCPB owns approximately 450 short-term, investment grade U.S. corporate bonds. The fund has an average duration of 1.9 years and a 1.4% yield.

10-15% PIMCO Enhanced Short Maturity Strategy (NYSEARCA:MINT): MINT is an enhanced money market fund, which owns investment-grade debt securities with maturities under one year. The fund has a 1.0% yield.

5% PIMCO 1-5 Year U.S. TIPS (NYSEARCA:STPZ): STPZ tracks an index of short-term inflation-linked Treasury bonds. Given that short-term TIPs bonds currently have slightly negative real yields, the returns from STPZ are driven by increases in the CPI (the consumer price index inclusive of food and energy prices), which are passed along to TIPs bond holders.

5% WisdomTree Asia Local Debt Fund (NYSEARCA:ALD): ALD owns government debt issued by twelve countries in the Asia Pacific ex-Japan region, including Australia, South Korea, Singapore, Malaysia, and others. The debt is denominated in the currencies of the issuing countries, providing exposure to currencies with attractive fundamentals and appreciation prospects. ALD is investment-grade, has an average duration of 3 years and a current yield of 2.8%.

Alternative Investments:

5% to 10% SPDR Gold Shares (NYSEARCA:GLD): GLD tracks the performance of the price of gold bullion. Gold continues to be supported by investment demand for a safe haven from potential economic and financial shocks, and from the debasement of paper currencies. The negative real interest rate policy recently reaffirmed by the Federal Reserve will continue to cause gold to appreciate in U.S. dollar terms. Gold is in a well-defined upward price channel (see Exhibit 4), and can be more safely purchased in the lower portion of this channel.

5% United States Commodity Index Fund (NYSEARCA:USCI): USCI provides exposure to a diverse group of 14 commodities encompassing the major commodity sectors. USCI employs rules-based strategies to mitigate the effects of contango (i.e. the negative return from rolling futures contracts) and take advantage of positive momentum trends.

3% Proshares Ultrashort Euro (NYSEARCA:EUO): EUO provides 200% inverse exposure to fluctuations between the value of the U.S. dollar and the Euro. This position provides a hedge to commodity positions and to risks arising from the European sovereign debt crisis.

3% iPath S&P 500 VIX Mid-Term Futures ETN (NYSEARCA:VXZ): VXZ is a hedge against possible stock market volatility and weakness over the coming six months. Currently, VXZ owns VIX futures that expire between August and November, and this term structure will be moved out one month as each month passes (i.e. next month the holdings will encompass VIX futures expiring September through December).

Exhibit 4: GLD at Upper End of Price Channel

Source: Mature Bull Market: Good Time to Lighten Exposure to Risk