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Use the Fed Subsidy to Your Advantage

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By Roger Whitney

"When the music stops, in terms of liquidity, things will be complicated, but as long as the music is playing, you've got to get up and dance. We're still dancing." Charles Prince, CEO of Citigroup, July 2007.

At the time of his remarks, Prince was referring to Citigroup's business of financing leveraged buyouts, and his observation that things would get "complicated" was, shall we say, a gross understatement. The music did in fact stop only a few months later, and his Citigroup ultimately required a massive federal bailout to survive.

Ben Bernanke: Credit AP

Today, we seem to find ourselves in a situation similar to the elevated market that preceded the financial meltdown and recession. Since early 2009, the Federal Reserve has increased its balance sheet from roughly $800 billion to more than $3 trillion in order to stimulate economic and employment growth, with the effect of propping up the stock market along the way.

Although several Fed policy makers currently feel that the bank should rein in its bond-buying policies, Chairman Ben Bernanke confirmed last week that he believes premature tightening would endanger the recovery. That means the plan to purchase some $85 billion of bonds each month until the job market improves will continue.

As financial assets (stocks, bonds, etc.) continue to feel the effects of the so far unending stimulus money, sober observers are uneasy. They rightly point out that it can't go on forever -- questions are indeed building about how long the intervention will last from here. What the outcome will be after it does stop, frankly, is unknown. At best, once the Fed tries to unwind its bloated balance sheet, interest rates will rise without the support of the bond purchases. At worst, we could revisit a near-economic collapse similar to 2008 as the flow of money into financial assets reverses course.

The truth is no one knows when the Fed's bond-buying policy will end (it can go on much longer than you might expect) and what will happen when it does. But that doesn't mean there aren't ways to try and make this work to your benefit for the time being. Rather than try to predict the future, let's focus on how to behave while the music is still playing.

Prudence above all else

If you're a long-term investor and need growth to meet your financial goals, then you'll need to participate, only do so at a pace that makes sense for you. Don't over-think things. Should the Fed start to pull back on its stimulus program and the economy and markets turn over, don't be surprised if the central bank rushes right back in. The Fed, European Central Bank and Bank of Japan have made it clear that they'll do whatever is necessary to support the world’s fragile recovery. Stimulus flushes money into the economy, money that must flow somewhere. So understand this, and act accordingly.

The clear winner among financial assets has been U.S. equities, as the S&P 500 has more than doubled since March 2009. U.S. stocks have been setting record highs and haven’t had a correction of over 5% for more than 180 days. At this point, if you are currently under-weighted in equities, it may be advisable to wait for a pullback before getting in. When you do, remain prudent – always be prudent. This MarketWatch column discusses the "Bernanke dare," along with the admonition that "investors who want to take a chance now need to keep perspective on the risk versus the reward.” Another way of putting it might be to know your comfort zone.

Don’t make the mistake of trying to keep up with broad market indexes. That's beside the point. Remember, you have goals to achieve. Know them, and focus on building a strategy that balances your need for income or growth with your desire not to experience an extraordinary drawdown in capital. The risk-free rate of return is virtually zero, meaning any return above that signals you have taken on some amount of risk. And do not forget that, as Prince correctly stated, when the music stops "things will be complicated."

One strategy is to create a risk barbell of sorts, pairing a higher-than-normal cash allocation with assets that have an inherent inflation hedge. Each person’s risk tolerance differs, but broad-based equity indexes, U.S. dividend-paying companies and midstream master limted partnerships are a great start for the risk end of the barbell. Good examples among individual stocks might be old tech companies such as Microsoft, (MSFT), Cisco Systems (CSCO) or Intel (INTC), each of which have strong balance sheets, generate ample free cash flow and have dividend yields of at least 2.6%.

The time likely will come when the massive fiscal stimulus isn't sustainable. It could end quite badly -- or it might not. What you can't do is dwell on trying to forecast the future. Don’t underestimate the ability for a seemingly unstable environment to last for a very long time. Instead, appreciate the forces acting on the market, and manage your risk.

As long as the music keeps playing, and you have future life demands to provide for, put your capital to use. Again, be prudent. Just be ready to get out on the dance floor.

Roger Whitney, CFP, CIMA, CPWA, co-founded WWK Wealth Advisors, a Registered Investment Advisor, in Fort Worth, Texas. He has specialized in investment management and planning for 23 years.