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Dear Mr. Fantasy play us a tune

Something to make us all happy

Do anything take us out of this gloom

Sing a song, play guitar

Make it snappy

You are the one that can make us all laugh

But doing that you break out in tears

Please don’t be sad if it was a straight mind you had

We wouldn’t have known you all of these years

-- Traffic, “Dear Mr. Fantasy”

The stock market remains intoxicated by the fantasy strummed by global policy makers. The trouble with fantasy, however, is that it eventually must give way to reality. And the longer the fantasy goes on, the more severe the hangover of reality may ultimately become for the global economy and investment markets. And given the mounting uncertainties as we move through the summer months, maintaining a diversified portfolio to protect against reality setting in is more important than ever now.

Do something, anything, to take us out of any gloom, make us all happy. Global policy makers have at their disposal the potions to placate investment markets – heavy government spending, easy money policies and regulatory oversight. Fearing a repeat of the Lehman episode that nearly collapsed the global financial system in September 2008, they’ve been offering these elixirs up generously - almost fearfully at times – ever since. Suspend mark-to-market accounting for technically insolvent banks, rescue industries in chronic decline, torture credit rating rules to prevent insolvent countries from technically declaring bankruptcy, engage in multiple rounds of quantitative easing, pump trillions of dollars in cash into the financial system and investment markets, etc. Do whatever it takes, and make it snappy.

This heavy stimulus helps keep equity markets laughing their way to new highs, regardless of any negative realities. Such continuous market joy, however, is not necessarily healthy for the economic or market system. When viewed through the scope of reality, should capitalistic investors truly be cheered by repeated government intervention in markets to put off an inevitable restructuring? The problem has not gone away, it has simply been numbed until August. And where will the next round of sedation be required? Ireland, Portugal, Spain, Italy, Belgium? Instead, the Greece rescue was a cause for fantastic market euphoria because we once again pulled back from the brink – for today.

But what about next time? And when? It’s only a week later and the Greece bailout is already facing new obstacles just as Portugal and Italy have come under renewed scrutiny. And what of the increasingly sluggish economic recovery in the U.S.? And the ongoing debt ceiling debate? And the effects of the end of QE2? The list of realities go on and on. And in these realities, all are reason to take pause, reassess risk exposures and act prudently. But the pleasure of stimulus and bailout fueled fantasy is that all of these risks can be ignored – the market will go higher simply because it will – at least for now. But for how much longer?

In trying to perpetuate the fantasy that all is well, global leaders are breaking down in tears from the pressures and political consequences of further bailout actions. Aggressive fiscal spending to try and rescue the global financial system has resulted in massive deficits that have constrained the flexibility of future fiscal policy. The independence of the U.S. Federal Reserve has come under intense scrutiny, particularly in the wake of what some deem to be an unsuccessful QE2 program and a ballooning balance sheet. Leaders across Europe are facing increasingly restless citizens that are either tired of bailing out their neighbors or do not wish to endure the pain to avoid default. Many politicians may soon find themselves replaced by new leaders ready to assume their roles with more blunt policy approaches to resolve the world’s problems. Tired of the fantasy, a growing legion are proposing that bailouts cease and creditors finally take some of the pain that should have been implied in the risks associated with their original investments in the first place. After all, isn’t the risk of loss part of what the capitalist market system is all about?

Many leaders had the straight mind to know what actions were needed to truly fix the system several years ago. But many either did not act or were unable to act in fear of scaring investors away from capital markets over the last several years. If we forced creditors to take a haircut on their loans, would the financial system seize up as lenders resumed hoarding capital? And what financial institutions might collapse under the weight?

Investors have rewarded these global policy efforts by staying around for all of these years. But how many years more? What is unfortunate is that the ongoing attempt to not let anything fail is also causing the opportunity to effectively repair the situation to increasingly slip away. After several years now, policy makers have now exhausted much of their remedies. Government budgets are stretched and monetary policy has been pushed to the limits in an effort to give the system time to heal and make right. But instead of seeing institutions face today’s harsh realities by lowering risk and changing behavior, many have instead returned to the fantasy that everything is once again well. By picking back up with old bad habits, some of which helped spark the financial crisis in the first place, the opportunity for these institutions to survive once reality sets in is fading further away.

Fantasies eventually give way to reality, and it appears that time is drawing close. Pressure is building, global unrest is becoming more widespread and capital resources to fund further rescues are quickly depleting. With a stock market that rallied so strongly over the last few years from its March 2009 lows and is now 40% overvalued relative to its long-term average historical valuation, it is reasonable to question how much further it can go before it succumbs to the underlying realities. This question is particularly timely today given the widespread market risks that, particularly over the last few months, have seemed to persist and mount with each passing day.

When viewing today’s market backdrop through the lens of reality, portfolio diversification is more important than ever in attempting to protect against loss and capitalize on opportunity. A portfolio that is focused heavily in the stock market is likely too concentrated in the current environment, even if these stock exposures are diversified across size, style and region. For example, if the market enters into a new crisis phase, stock portfolio diversification across growth/value, large/small, domestic/international will simply not be enough, as virtually all stock categories will likely get pulled sharply lower. This is a crude reality that is still all too fresh in the minds of many investors from just a few years ago.

Instead, locking in healthy gains and reallocating out of stocks into other asset classes would offer meaningful value in protecting against risk and ideally providing a more consistently positive returns experience. If a new crisis phase were to erupt, asset class categories such as U.S. Treasuries, gold and non-financial preferred stocks could be expected to perform well in such an environment. Even without a crisis but with the market simply adjusting to the realities associated with the end of QE2 and the weakening economy, each of these three categories as well as investment grade corporate bonds and high quality defensive stocks including consumer staples and utilities should all be expected to perform well. And depending on the severity of the situation at any given point in time, reallocating to cash may also have merit. After all, stepping aside for a near zero rate of return is always meaningfully better than enduring a double-digit decline.

One additional point that is worth mentioning – preparing for the potential realities in a 401k plan can be particularly complex right now for several reasons. First, the mutual fund menus found in most 401k plans are often heavily biased to stocks. As a result, investors may feel diversified because they own several stock funds when in reality they are quite concentrated in a single asset class in stocks. In addition, it is often more challenging to fine tune your exposures both across and within asset classes given the limited fund offerings available in most 401k programs. Also, the desire to move to cash in a 401k plan may be complicated by the fact that “cash” is actually a money market fund that might be exposed to risks associated with the mounting crisis in Europe. Thus, it may not be as simple as just moving to “cash” in your 401k in trying to move to the sidelines. I will be checking back soon with some baseline strategies for how one might reallocate a 401k in order to try and protect against prevailing market risks.

Of course, despite all of the prevailing reality risks today, the fantasy may continue for some time and the stock market may continue to elevate to new post crisis highs. But it is worthwhile if nothing else to consider using this opportunity to reallocate stock gains and diversify across asset classes in the event that the hangover of reality were to finally set in.

Disclosure: I am long GLD, LQD, ALM, FGE, XCJ, DRU, IEI, IEF, TLT, LNT, WR, PG, CL, CLX, KMB.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Source: Time to Move to Cash?