A portfolio for pessimists

By Jim Jubak

If you're a true pessimist -- and the number of those has swelled recently -- you know a rally like that which began on June 13 doesn't really change anything.

It's just a trap, a fake to get you feeling good about stocks, so that the market can slam your portfolio again. Sure, now stocks rally, now that the financial markets have decided that the odds of the Federal Reserve interest-rate hike at the end of June are 100%. But what about an August increase? Aren't worries about that just around the corner?

If you're feeling pessimistic about stocks right now, you're certainly not alone. A drop of 8% in the Dow Jones Industrial Average ($INDU, news, msgs)and 11% in the Nasdaq Composite ($COMPX, news, msgs) from May 9 through June 13 has turned plenty of us into pessimists. Watching the even bigger declines in the small-company Russell 2000 Index ($RUT.X, news, msgs) -- 14% -- or in foreign indexes, such as the 20% drop in Japan's Nikkei 225 ($US:N225, news, msgs), doesn't help the mood any.

It will take more than a two-day rally to turn that mood around for many investors. And feeling pessimistic at a time like this is understandable and perfectly appropriate.

But just as getting too optimistic is likely to cost you at market tops, getting too pessimistic will exact its pound of performance flesh at market bottoms.

At a time like this, when thoughts turn to the dark side, it's good to think about exactly how pessimistic you are -- and should be. Pessimism, like optimism, comes in all kinds of flavors and degrees. Do you belong to the "It's nasty but normal" school or to the "Bury the gold, Martha, and pass the ammo" camp?

In this column, I'm going to lay the "big picture" groundwork for developing what I call The Pessimist's Portfolio. In my next column, I'll give you some individual stock picks for building The Pessimist's Portfolio. It's a relatively short-term portfolio, designed to take you through the next 12 months. It begins with an attempt to gauge exactly how pessimistic you are -- and then to examine if your worst nightmares hold up in the light of day. I'll then show you, in my next column, how to construct a portfolio that's the best way to navigate the market, even if your pessimistic vision turns out to be accurate.

When it comes to developing an investment strategy, your degree of pessimism matters. And the easiest way I know of to measure that pessimism is to build a scale of pessimistic scenarios from best-of-the-worst to worst-of-the-worst.

Pessimist's Scenario No. 1

Not much has changed. Despite all its saber-rattling, the Federal Reserve isn't really all that committed to fighting inflation to the death. In fact, all the tough talk about fighting inflation is a prelude to a pause after a June or maybe an August hike in the Fed's series of interest-rate increases.

(And, yes, for the record, it looks like my May 12 column, "The Fed is done hiking rates (for now)," is going to turn out to be dead wrong. The Fed funds futures market has priced in the odds of a June 29 interest-rate increase at 100%.)

The world's other central banks, after getting strong political opposition, also decide enough is enough by the end of 2006. This would lay the foundation for a fourth-quarter rally in stocks and a drop in prices at the long end of the bond market as investors become convinced that inflation isn't dead. But it wouldn't be good news for stocks in 2007.

This policy shift would leave the world awash in relatively cheap capital (although more expensive than in early 2006) and leave inflation to continue its recent climb. The central banks and the financial markets would have to fight the cheap-money battle all over again on less favorable terms (and with another stock market tumble) in 2007. The U.S. dollar would fall with the end of Fed interest-rate hikes, adding to inflation, but economic growth ends the year stronger than now expected.

Pessimist's Scenario No. 2

The central banks raise interest rates until inflation cries uncle. But they overshoot and crush economic growth, too. Emerging markets sink further as money gets more expensive and competing yields in developed markets climb.

The higher energy and commodity costs now finally creeping into consumer prices may leave the central banks no choice. The U.S. consumer price index (CPI) announced on June 14 was very bad news in this context. For May, the core (that's inflation without energy and food) consumer price index climbed 0.3% to an annualized rate of 2.4%. That's matches the February 2005 rate, which was also a four-year high. (The core consumer price index hit a 40-year low of 1.1% in 2004.)

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