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A time for short-term bonds and stable stocks

To invest properly during turmoil, it is useful to have a framework that can help you put market conditions in context.

One such framework was suggested by investment prodigy Richard Farleigh, an underprivileged boy from the Australian outback who put himself through university, then ran the highly successful proprietary trading desk at Bankers Trust Australia, before starting a Bermuda-based hedge fund.

Mr. Farleigh divides the investment environment into four scenarios, based on GDP growth and inflation. In each situation, a different set of assets does best. Here are the four scenarios, and the top investing strategies for each:

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1. In a high inflation, high growth environment, you load up on commodities.

2. In a low inflation, high growth environment, you highlight stocks.

3. In a low inflation, low growth environment, you emphasize bonds.

4. In a high inflation, low growth environment, you are likely to lose money no matter what you do, and so should aim mainly to protect capital.

Where are we today? I believe we are in the first scenario. While core inflation numbers remain low, prices for gasoline and food are surging. Central banks are creating massive amounts of money, which is driving commodity prices higher and making millionaires out of folks who invested early in junior gold mining stocks.

All four circumstances are temporary, but the current one is the most unstable of all, because growth based on inflationary money-printing ends in one of two ways: either in social disorder (see: the French Revolution, 1920s Germany, 1970s Brazil), or in central banks having to raise rates to brutal levels to stem the inflation they've created.

So where are we likely to go from here? For now, we can rule out the second scenario - the promised land of low inflation and high growth. There is no way to squeeze inflation without quashing growth, nor keep growing the economy via repeated rounds of government stimulus spending without stoking inflation.

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What's left then is either the third or fourth situation. One way or another, lower growth is now a near certainty. The only question is the direction of inflation. And that depends on whether policy makers choose to endure social disorder or subject the economy to a painful squeeze from higher interest rates.

Pain, Either Way

In some places - notably the Arab Mideast - social disorder is the likeliest alternative. Yet such places constitute only a small part of the world's GDP.

In the much larger economies of the West, some central banks are already beginning to raise rates, and more are likely to follow. In addition, the U.S. Federal Reserve is likely to stop its policy of quantitative easing by this summer, which means an end to Washington's policy of creating money.

All of this means that both economic growth and inflation should moderate in the near term. Most likely, we will shift to the third scenario, the "Japanese quadrant" of low growth and low inflation.

A move in that direction should strengthen bonds. At the same time, high quality stocks with predictable long-term earnings - IBM, for example - should continue to do well.

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But what if short rates do not rise enough to reduce inflation? Or if the U.S. administration chickens out and fails to withdraw stimulus? Then we would be in the fourth situation, a stagflationary period of high inflation and low growth where everything does badly except perhaps gold.

No matter what inflation does, the economy is likely to soften, which means that soaring commodities are likely to fall back to earth. I would advise against holding a lot of them. I'd also suggest shifting away from higher volatility stocks in favour of more stable, dividend-paying ones. As preparation for the third scenario, you should look at convertible bonds, preferably of shorter maturities, while leavening your portfolio with a dash of gold as insurance against the fourth scenario.

It's not exactly a paint-by-numbers investment strategy, but it's close. Just the thing for these volatile times.

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