2011: The U.S. Year (Bernstein)

The economic and financial conditions that made traditional alternative investments attractive have significantly changed. Typical alternative assets were particularly attractive when treasuries had a positive correlation to equities (and, therefore, provided little or no diversification to an equity portfolio), and when credit was cheap and widely available.

Through much of the 1980s and 1990s, old-fashioned stock/bond/cash asset allocation did not work well because the stock market was in an interest rate-driven/PE-driven phase. The stock market rose when bond prices rose, and the stock market fell when bond prices fell. Because stock and bond returns were positively correlated, investors had to search for investments that had low or negative correlation to stocks in order to diversify their portfolios. Today, stock and bond returns are generally negatively correlated (see Chart 3), and old-fashioned asset allocation has again been working. At the same time, the returns of nearly all alternative asset classes have become highly correlated to equities.

In addition, most alternative asset classes are credit-based. The extended period of cheap and easy credit helped fuel the performance of alternative investments. Since the deflation of the credit bubble, however, such financing has become considerably harder to obtain.

The fees associated with investing in treasuries are much lower than in traditional alternatives, and the treasury bond market is the most liquid market in the world. There are no lock-ups, side pockets, or gates and investors donā€™t need to ask permission to get their capital returned when investing in treasuries.

Thus, the conditions that favored investing in alternative assets no longer seem to exist. Bonds are negatively correlated to equities and alternatives are positively correlated. Credit conditions have tightened significantly making the leverage associated with alternative investments more difficult to obtain and more expensive. Traditional asset allocation now seems much more attractive to us. Treasuries may be the new ā€œalternativeā€ asset.

US stocks continued to outperform BRIC
History shows well that periods of extreme equity market volatility are typically followed by a change in leadership. The growth stories going into a period of volatility are rarely the growth stories coming out. Volatility is a signal to investors that the underlying economic fundamentals are changing. Stock market leadership going into a period of volatility is typically geared to a specific economic environment. As the environment changes, old leaders correct, new leaders begin to emerge, and the markets become quite volatile because of the related uncertainty.

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