What to Invest In, and Not

The classic investor questions are: Where is the market going, and what can I do about it? Get ready for lower U.S. corporate margins, a dropping dollar and opportunities in industrial materials and utilities.
First, let’s examine where we have been.
The world’s equity markets at the end of 2011 were marked by uncharacteristically high levels of perceived risk.  Many investors remained deeply pessimistic about the ability of eurozone nations to come to a meaningful agreement regarding the debt crisis that had plagued many of their member countries.  Market commentators speculated that a “worst case scenario” situation for Europe and many were calling for a seemingly inevitable break up of the currency union.
None of the dire predictions came true.  On the contrary, Greece moved toward passing new austerity measures, the European Central Bank injected unprecedented liquidity into the banking system, spiraling commodity prices moderated and investors were relieved.  Progress in Europe, combined with improved fundamentals in the U.S., helped spark a strong rally among stock markets worldwide.  The first quarter of 2012 was the strongest January-March period for U.S. equities in well over a decade.  In emerging and developed countries, stock markets also rallied.  Investor sentiments clearly shifted to “risk on” behavior in a major way. 
The bond market, unsurprisingly, underperformed in the first quarter of 2012.  The returns ranged from flat (for bonds with shorter maturities), to slightly negative (for bonds with longer maturities).  As investors took on more risk, the prices of safe-haven U.S. Treasuries dropped.  Foreign bonds, however, rebounded strongly from last year’s weaknesses as investors once again became more comfortable with owning lower quality sovereign debt. 
Unfortunately, the euphoria subsided as quickly as it arrived. Disappointing economic data from Europe at the beginning of the second quarter signaled a shrinking manufacturing sector in Germany, and renewed geopolitical uncertainty in France raised concerns about the eurozone’s commitment to contain the debt crisis.  World’s markets pulled back at the beginning of the April, and investors once again start pulling money out of equity funds.
Up ahead, the remainder of the year, equity investors may experience more muted returns in the near term, but should be well rewarded in the long-term.  Although U.S. corporate profit margins remain far above historical norms, many analysts believe that they are not sustainable, because hungry foreign companies will charge lower prices and eat into American competitors’ returns.
Therefore, equity investors should look to sectors that will do well in such a situation, such as industrial materials and utilities. The U.S. has strong positions in industrial materials (aerospace, defense, chemicals, machinery, commodities) and utilities have no foreign competition.
Fixed-income investors should be rewarded for taking on additional credit risk by investing in lower quality paper, but still investment grade bonds both in the U.S. and abroad will pay good income with less worry. American investors in sovereign debt (government bonds of other nations) should choose obligations denominated in local currencies. Reason: The U.S. dollar is likely to depreciate against the developed world, whose higher interest rates will result in their currencies getting bid up. Investors will be smart to keep the maturities short amid rising rates around the world in the next few years.
Attractive opportunities are in alternative strategies, especially those designed to generate yield. Master limited partnerships, which invest in pipelines that transport oil and natural gas throughout the U.S., are good examples. Similarly, real estate investment trusts (REITs) provide meaningful returns amid today’s low yields.  But income is only part of the investment equation.  Capital appreciation – increases in the underlying prices of the asset – is equally important.
Going forward, investors will be well served by tactically allocating and rotating among various asset classes. As always, investors should construct well-diversified portfolios that have exposure to multiple asset classes in stocks, bonds and alternatives to minimize volatility.
Andrew B. Chou, CFP, is a senior portfolio manager at Westmount Asset Management in Los Angeles, Calif.

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