Market Update — Investing for the future

Ted Truscott, Chief Investment Officer — RiverSource Investments, LLC
Nov. 6, 2008

The uncertainty around the outcome of the presidential election has been one of the factors weighing on the markets of late. The election of Sen. Barack Obama removes this uncertainty and we will soon begin to see which policies he chooses to follow. I have never been too big a fan of developing investment strategies based on political outcomes. They are very unpredictable and I am much more interested in the economic/business climate, how companies react to the prevailing environment, access to credit, earnings, and most importantly, the price of stocks and bonds in the marketplace.

There are two scenarios likely to play out in the coming months, into next year. These scenarios are set forth below and while the investment strategies that grow out of them are different, some aspects of the environment will likely be the same. For instance, I believe the era of conspicuous consumption is over. Call it a national mood change that reflects a backlash against the excesses of Wall Street, a rejection of debt as a way to improve lifestyles and a new environmental consciousness.

There are probably other factors at work here as well. However, ask yourself what I call the Starbucks question: Are the current woes affecting Starbucks the result of a flawed business strategy or a national mood change that rejects premium priced products? Has the day finally arrived where we would rather save than buy a Starbucks latté? Heaven forbid — could it be that the new fashion is to trade down to the coffee sold at McDonald's?

No matter what the scenario, it's going to be a tough world for those companies who are not the number one or two competitors in their industries. This will be particularly true in retailing, restaurants, autos and other discretionary areas of spending. Too many weak competitors have been kept afloat by easy credit and consumers living beyond their means. This recession will likely wipe out marginal players. Even dominant players will be challenged by a tough recession, and painful adjustments and cost cutting are now the order of the day. Both equity and bond investors report a steep decline in fundamentals and, therefore, the next wave of this downturn will be an increase in bond defaults.

Set forth below are descriptions of the two scenarios I envision and the associated probabilities for each. No one has a crystal ball in this business and it is possible that neither scenario will be realized. It is also possible that some combination of the two eventually becomes reality. The associated strategies are generic and not quantitative. You and your appropriate financial advisors should tailor these generic strategies to your own situation.

Beyond this, RiverSource Investments has very specific asset allocation recommendations that are built into our advice-embedded products such as the RiverSource Portfolio Builder Series, RiverSource^® Strategic Income Allocation Fund and Ameriprise Active Portfolios^® investments. These portfolios have different time horizons and constraints, and may be very different from the generic recommendations below.

Disinflation/deflation (30% probability)

In this scenario we see consumers, finance companies, investment banks and insurance companies continue to deleverage on a large scale. Home prices continue to fall in a difficult cycle where falling prices create additional foreclosures, which beget further declines in prices as more homes are dumped on the market. The government and its agencies, including the central bank, use all their powers available to slow or stop the decline in home and other prices but are ultimately unsuccessful.

Consumers retrench on a level not seen in many generations. Saving becomes a virtue and consumers discover that they really do not need all of the stuff they have been purchasing over the last two decades. They also discover something else that they previously thought only happened with computers and TV sets. If they wait, prices are generally lower for almost all goods and some services than they were just a few months before!

Debt is a four-letter word in this environment. Because debt is fixed, high levels of debt in an environment of falling prices becomes a crushing burden. Highly indebted consumers and companies fail under the weight of excessive debt.

This scenario has a lower probability and many will argue vigorously against it. Many believe our consumption-based economy is deeply entrenched and will not change anytime soon. Not since the 1930s has this country faced the twin specter of deleveraging and a steep fall in asset prices. In short, consumers may be forced into an environment of saving and debt reduction whether they like it or not.

In the late 1980s, Japan witnessed the end to an asset-priced bubble. A large contraction in credit and steep fall in asset prices were the hallmark of the "lost decade," and the conditions look very similar in many respects to what we face now. The Japanese government and central bank made numerous policy mistakes and while it took a few years, a disinflationary environment took hold and Japan suffered a decade-long period of economic stagnation (Tokyo land prices fell by 50%). Japan is my guide to what this scenario looks like, although cultural and governmental differences mean that the U.S. version of deflation may look a bit different.

In this deflationary scenario, I would recommend the following portfolio. Note that an asset class is suggested and I've also included an example of a RiverSource fund(s) that most closely matches the asset class — as I am more knowledgeable about RiverSource products than non-RiverSource products. My providing an example of RiverSource-specific funds should not be construed as a recommendation to buy or sell any particular RiverSource fund, and other products may be more suitable for an individual investor based on the specific needs and circumstances of that investor. An investor should consult with his/her financial professional before purchasing any security to ensure it is a suitable investment and consistent with his/her investment plan and long-term objectives.

• 30% U.S. Treasury notes/bonds (10 to 30 years)
• 20% Global government bonds (RiverSource Global Bond fund)
• 30% Global companies that have low levels of debt, pay dividends (the higher the better), make products that are consumed in most any environment and can sell anywhere in the world (Threadneedle^® Global Equity Income Fund/RiverSource Dividend Opportunity Fund/RiverSource Disciplined Equity Fund)
• 20% Cash (cash will not be trash in a deflationary environment)

Reflation (70% probability)

In this scenario the government continues its strong intervention in the economy. It continues taking equity stakes in banks and extends that policy to insurance companies and other components of the financial system, including automobile financing companies such as GMAC. Bernanke and the Federal Reserve introduce "quantitative easing" where interest rates are taken down close to zero in order to ward off deflation. The government enacts another fiscal stimulus package that passes with ease thanks to the Democrats' control of both the White House and Congress. These policies err on the side of re-igniting inflation deliberately because the Fed knows how to fight inflation. Deflation is avoided at all costs as the remedies are mostly theories in text books.

The economy then contracts as described in Dan Laufenberg's forecast for the first half of 2009, but the bond and stock markets sense that government policy is working and will continue to work. Despite increased bond defaults, higher unemployment and continued consumer retrenchment, investors flock to bargains in the bond and stock markets. World markets also benefit from policies enacted by European and Asian governments. Emerging markets get an additional boost to already solid growth rates.

Portfolios are easier to assemble under the reflation scenario because so much is on sale in both the bond and stock markets.

I would recommend the following portfolio in this scenario:

• 25% Investment-grade corporate bonds (RiverSource Diversified Bond Fund)
• 15% Loans (RiverSource Floating Rate Fund)
• 10% High-yield bonds (RiverSource Income Opportunities Fund/RiverSource High-Yield Bond Fund)
• 20% High-quality large cap U.S. stocks (RiverSource Dividend Opportunity Fund/RiverSource Disciplined Equity Fund)
• 10% International (any RiverSource international offering)
• 5% Emerging markets equities (RiverSource Emerging Markets Fund)
• 15% Cash (to be used to fund additional purchases through dollar-cost averaging and as safety in case the economic scenario is worse than forecast)

Our reflation scenario calls for a fairly high mix of bonds because we see more value in the bond market than the stock market. This approach is fairly consistent with David Joy's most recent mix in the moderate version of the RiverSource Portfolio Builder Series. He is underweight on domestic and foreign equities (41.6% weight), neutral on bonds (50.6% weight) and has 7.8% in cash and the currency fund.

Risks/further analysis

I will start by saying that I believe we are in a single-digit return world. This means that if markets recover, we are likely to experience single-digit returns in stock and bond markets. Clients should adjust their thinking to this new reality and increase savings or lower amounts withdrawn from retirement accounts in order to adjust to the new reality.

As with any type of prediction, there are risks to both these scenarios. As Jamshed Kahn (our lead data analyst) has noted, we could see a rebound from our October 2008 lows followed by a new low that is reached sometime in 2009. This would repeat a pattern seen in the 2001 to 2003 period and might occur if economic news continues to disappoint despite a government policy that staves off deflation.

The following chart shows the two lows reached in the 2001 to 2003 periods as exemplified by the green and red bubbles. This is one reason why we advocate higher levels of cash than might normally be held in a portfolio. Please note that this level of cash is above and beyond the approximate three to six months' living expenses that most advisors recommend be kept in cash.