This lengthy educational report for the Trader Kingdom audience reviews the merits and shortcomings of portfolio diversification, the upcoming “restructuring cycle” for CRE and LBO’s of the credit cycle boom that burst in 2007, and the bone-crushing impact this recession is having and will continue to have on unemployment and state and local budgets. Trader Kingdom readers wishing to gain insight into the macro picture and challenges that we as traders and investors will be facing over the next three to four years please read on.

Risk is ubiquitous. Markets misbehave. Financial crises are hardy perennials. Wall Street crashed. The private sector blew up. Again! Yet in 2009 U.S. policymakers managed to extinguish the raging fires on Wall Street. By all appearances it would seem that our policymakers have orchestrated a successful rescue of both our stock market and by proxy our economy. And our policymakers do concur with that view:

US Treasury Secretary Timothy Geithner told NPR’s Michele Norris in a December 22, 2009 interview that “the policies that the president put in place are helping lay the foundation for growth and job creation…American’s “can be more confident about their financial future, financial security” promising that “We’re not going to have a second wave of financial crisis. That is something that is not acceptable and we will prevent that.” Blah, Blah, Blah…

But have the “Nunca Mas” policies that the administration put in place, are they really sufficient? Have policymakers really tamed the misbehaving financial markets that hold the private sector of our economy hostage? Have they really brought to heel the marauding Wild West of the OTC Debt and Derivatives markets that drove our economy to the brink of a Great Depression? In short, can the US Treasury Secretary really claim that all is well, and will be well now? Most importantly, can Americans really be confident about their financial futures and secure in their jobs? Or is there to be a malevolent and violent backlash to the private sector boom that went bust in 2007-2009?

On general principles, history suggests risk has not been eliminated by the policies put in place in 2009. History indicates risk can’t be fully decomposed, nor can markets be fully tamed. And crises, well, crises, they just happen. Confronted with these realities, portfolio managers devised models long ago to help investors decompose market risks. It’s called diversification. Standard and Poor’s analyst Sam Stovall asked a pertinent question in 2009, “Did diversification fail during this bear market?” To answer his own question, Sam created a theoretical model charting the total returns of a weighted portfolio that was 60% SP500 equities and 40% long term US Govt Bonds. In 2008, it shows this diversification model lost -13%.

Given that a total equity portfolio comprised of the SP500 lost 39% in 2008 (before dividends), it is clear that this particular diversification model may have absorbed some of the shock for investors because the losses in the SP500 had been partially offset by 19% year-end gains (before interest) in the 30 year Gov’t bonds. At first blush, Stovall’s diversification model appeared to have been a fairly effective if rather blunt tool in 2008.

Click on image to enlarge!

But is diversification sufficient? Sam’s diversification model dating back to 1929 shows a highly erratic model whipsawing in and out of negative territory. What is more, as we shall see, Stovall’s diversification model behaved much like a boomerang in 2008-2009. On balance, if diversification could fully tame market risk, the oscillations shown in this model should have been much smoother. The premise of diversification, then, appears valid, but insufficient to protect investors from excess market volatility.

Upon closer examination of Stovall’s model, too, it was only by a bizarre sequence of non-recurring events in the final 2 months of 2008 that even made it at all possible for the long term bonds to offset the steep losses in the stock market. To wit, most of the 30 year treasury’s 19% gains in 2008 occurred after Ben Bernanke’s December 1 2008 quantitative easing statement and his December 16 2008 race to embrace a zero interest rate policy. Barring these extraordinary policy actions in December 2008, there would have been little to no offset holding long term government bonds. Moreover, the fixed income holdings of actual balanced portfolios for most investors were not 30 year long term bonds. Hence it is likely that the majority of balanced portfolios did not benefit at all from the special actions of Ben Bernanke in December 2008.

If diversification is not a stand alone tool, what then can investors do to smooth out market risk and volatility inside their balanced portfolios? I submit that investors take a slightly more active risk management approach than simple diversification. Returning to Stovall’s theoretical model, we note the bear market of 2008-2009 exposed a boomerang effect in total returns. What goes up largely in one year tends to go down significantly in the next. During years that produce high returns in long term bonds as happened in the 30 year bond in 2008 (up 19% y-o-y before interest), it would have made sense for investors to reduce their exposure to long term bonds in 2009 when the 30 year lost more than 16% y-o-y of its value. Likewise, during years that produce high stock market returns such as 2009 did (up 23.4% y-o-y), investors should anticipate that subsequent years are apt to reflect lower or negative stock market returns (for example, what could potentially occur in 2010-2012) as valuations and other market considerations might become unsustainable.

Taking an active risk management approach towards diversification for investors entails rebalancing asset allocation mixes to reflect shifts in market risks. Investors can rebalance equity and fixed income weightings upward or downward on an annual basis to achieve the desired mix. For example, in the three years subsequent to 2009’s positive equity returns, the proper allocation mix of a diversified portfolio might be 40% equity and 60% fixed income, or less depending on your risk tolerance.

Rebalancing one’s asset allocation mix is an underutilized tool. Investors tend to neglect rebalancing their portfolios much because they are generally advised to just overweight equities when they are young and overweight fixed income when they are old (I suffered from this flawed approach to investing in the 1987 crash). Overweighting equities does nothing to help a younger investor avoid downside market risks. To illustrate this simple but very important point, consider the theoretical young investor that made his or her initial equity investment in the SP500 on January 1 2000. Ten yeas later on January 1 2010 that initial investment would be down 25%. So much for that head start in life

When the stock market misbehaves erratically, it behooves investors to heed these market signals and rebalance downward to reduce their equity exposures for a spell until the headwinds pass. Once the storm passes, then it is time to consider rebalancing these equity positions upward or not. While 2009 did generate generous stock market returns for investors it won’t be too long now before the market risks and headwinds we faced in 2007-2008 return.

The balance of this report will address the potential malevolent and violent backlash American’s will face in 2011-2014 from the private sector boom of 2004-2007 that went bust. Specifically, this report will look at how the restructuring cycle of the debt created in the previous 2004-2007 commercial real estate the leveraged buyout (LBO) boom era will impact the economy and the lives of nearly all Americans in 2011-2014, notwithstanding the Treasury Secretary Geithner’s false reassurances. Moreover, readers should pay heed to the prevalence of “lax underwriting” standards for commercial real estate (CRE) loans and the “covenant-lite” structures of the LBO loans during the boom years. The lack of safe and sound underwriting standards for both CRE and LBO loans during the boom cycle present downside risks to the debt restructuring scenarios presented below.

Before presenting the details of the up and coming restructuring cycle, it is worth pausing for a moment to consider the investment advice President Obama gave Americans on March 3 2009: “What you’re now seeing is, profit and earning ratios are starting to get to the point where buying stocks is a potentially good deal if you’ve got a long term perspective on it.” Unfortunately, President Obama looked right past the heap of trouble the financial markets and U.S. will face in 2011-2014. This will likely prove to be a big mistake, comparable to the mistake Greenspan made in 2004 when he advised folks to secure their homes using ARMs.

For more from John Bougearel, visit Structural Logic