Relative Calm

This week the U.S. stock market returned to something resembling normalcy, but it may not last long. All those bad mortgages are still bad. Lay-off announcements in the financial sector are becoming a daily event, and the Bernanke Fed is not yet instilling confidence in its crisis-management abilities. Traders remain reluctant to carry big positions overnight.

After a steep rally from last Thursday's low point, the major benchmarks may have exhausted their short-term momentum. Today the Dow, S&P 500, Nasdaq and Russell 2000 all fell back from early gains to close with small losses. Sector action is still quite choppy. Financials surged higher in the last week on hopes of an interest-rate cut, but basic materials were even more impressive. Today, however, both these sectors were easily overshadowed by energy and technology.

The current market environment is especially challenging for one overwhelming reason: no one knows if, how or when the Federal Reserve may intervene. Of course there are many reasons to be bearish right now. Yet anyone who takes a short position, especially with leverage, could wake up to a rude surprise if the Fed announces a rate cut early one morning. Conversely, if the Fed is unsuccessful in stabilizing the credit markets there is a lot more potential downside ahead. This makes it hard to justify additional equity exposure. So by default many investors are raising cash positions. Not just any cash equivalent will do, however; the market for commercial paper is shrinking quickly. Investors demand the safety of treasury bills, where yields are still substantially lower than they were two weeks ago.

Most investors are currently of a mind to avoid risk. There is more than one kind of risk. There is the risk of being in a market that is heading down, yet there is also the risk of not being in a market when it goes up. The best strategy is to balance these two types of risk, which is why our model portfolios currently hold a mixture of cash and equity funds.