The third quarter of 2011 saw wild swings – both down and up – across U.S. investment markets. While many reasons were cited by professional economists and analysts, the common theme was uncertainty. To help clarify some of the unknowns creating angst for investors – and to give those investors ideas about how to deal with what many believe will be a persistently volatile marketplace in the near term – Baird assembled a panel of experts for the following Q&A.

Q: What are some of the major factors contributing to the uncertainty economists cite as the cause of current volatility?

Bittles: Europe is on the front burner right now, and there are still many unknowns concerning how the sovereign debt issue is going to be resolved. We hope the banking system will be shored up, and that we won't have a financial crisis that could spread across the globe. We expect the European central banks will support the debt throughout Europe, but this will likely lead to a very slow growth period for Europe, possibly lasting several years as austerity is replaced by heavy leveraging and borrowing. That's the largest threat on the table right now.

The United States is also a source of uncertainty. The question is whether we are going to slip into another recession or if our economy is going to grow. I think the answer is probably in between. For quite a while we’ve forecast a very slow growth economy. And by slow growth, I mean GDP growth of 1.5% to maybe 2% for two to three years. The debt bubble that burst in 2008 continues to unravel and cause deleveraging throughout our economy. So if you expect the consumer to lead the recovery, I think you’re going to continue to be disappointed. The average household now is very busy trying to pay down debt and many are starting to save more. However, it is this dynamic that makes me bullish over the longer term.

I've been worried about the debt problem for at least ten years. We've always compared the total debt in our country to the size of the economy and, with debt four times the size of the economy, obviously that made growth difficult. It was a situation loaded with risks and we saw what happened when the majority of the nation ignored the issue. Now, however, you can't pick up a newspaper or turn on the evening news without hearing that four-letter word: d-e-b-t. The fact that the country has taken the first step, admitting we have a problem, is huge and eventually it's going to lead to some solid policy out of Washington.

Now there will still be some fighting in Washington, and you can already see it happening. But I think the debt super cycle has concluded, and the pendulum is going to swing all the way to the right. I think we’re going to see a flat tax, which will be essential to growth in the years to come. I think we will finally have an energy policy and I think it will focus on oil and gas. I think we will have policy in place putting spending caps on the government. I know that all seems far-fetched right now, but I think the mood of the country is leaning in that direction, and once the momentum of that pendulum shifts, it often goes farther than you ever believed it could. This is what I believe will eventually lead to a new secular bull market in the economy and in stocks, and will get us back to a more normalized interest rate environment.

Q: Looking back over the past few months of volatility in the markets, have there been asset classes that performed better than others, and, if so, why?

Bittles: What we’ve seen recently is very similar to what took place in 2008, when virtually everything was impacted adversely. And there have been very few places to hide from it. The government bond market has done extremely well, but of course that's out-performed the stock market for the past ten years or more. So that's not terribly surprising. I'd also say gold has performed well, despite a correction late in the third quarter, and it's been the outstanding asset class of the past ten years as well. Apart from those two areas, however, it's been a very broad-based decline, which is worrisome because it suggests that the primary trend continues to be down. And by broad-based, I mean not only have all U.S. economic sectors been negatively impacted, but also most of the global markets. As of the beginning of October, I’d say only 2% of global markets are above their 200-day moving averages. So everything has been going in the same direction.

In terms of change we’d like to see, we need some positive divergences to develop, and what would really be encouraging would be if they develop in the financial sector. Typically financials are a leading indicator for the rest of the market. As go the financials, so go the markets. This year financials have been under-performing significantly, and that's been a huge negative. We don't see any positive divergences developing yet.

Now, historically, the third quarter of the year is typically the weakest seasonal basis for the market and the fourth quarter is the strongest. With pessimism as thick as it has been, our feeling is that the worst is over – at least for the time being, and at least for stocks. At some point, we're going to gain some traction later in the fourth quarter. But the weight of the evidence we use continues to suggest we should remain defensive until we start to see some positive developments.

Q: You touched earlier on the notion of the consumer not being able necessarily to lead us out of the recession. The lack of purchasing power out there seems to be one thing fueling speculation that we're either headed for another recession or, perhaps, are already in one. Is that likely?

Bittles: We're still holding to the point of view that the economy will not go into recession in the near term but, rather, remain on the edge and in slow-growth mode for an extended period of time. That’s not to say there aren’t plausible arguments against that view. Indicators that have been very reliable in the past – particularly the action in the commodity market – would suggest that the economy is moving into recession if not already there. Certainly the collapse in commodity prices in the last three months is worrisome. Also, the outperformance of the bond market and the action in yields suggest the economy may be on the edge of recession. But we're not giving that as much weight simply because of the Fed intervention we’ve seen there. We’re really focusing on the commodity markets. Finally, the stock market is a pretty good indicator. If the market would take out the lows that we hit in the summer of 2010, which were around 1040 on the S&P 500, that would be an indication that the economy is in recession or is soon going to be. So we're watching all of those things very closely. But right now our outlook is for the economy to continue on the edge.

Langenfeld: Bruce, on the fact that the market is a leading indicator and could signal whether a recession is under way, clearly the volatility has been there. Even with the recent uptick, the volume hasn't been there. So how do you interpret that? Because I would tell you, on the transportation side, as an example, if you go back and look at the market downturns in a recession, transportation has always been ahead of the recession. And we haven't seen that yet on the transportation side in terms of fundamental trends. The stocks have reacted, but some of the trends have not. So it's kind of interesting to watch.

Bittles: Well, the transports are one of the better leading economic indicators, and the transports did make a new low in this cycle. But I still think that the stock market as a whole, using the S&P or the Dow, is really the key. If that can hold above the August 2010 levels, that would argue against a recession. So we're watching that much, much more closely.

Q: Investors have been hearing and reading a lot about the low-yield environment we’re in right now. Does this automatically make fixed income investments less attractive?

Stanek: As investment managers, our primary concern is really risk management. We’ve always said: "Beware of the consensus." Until recently, the consensus thought interest rates had to rise. For the last several years, just about every forecast we looked at incorporated the view that rates were so low that they had nowhere to go but up. We appeared to be out on a limb because we thought rates would stay lower longer than people expected. And now it looks like they will.

Meanwhile, investors have re-priced risk, largely because of headlines relating to the substantive issues Bruce covered in his opening. This repricing has occurred at a time when volatility has also picked up. As a result, investors have sought out some kind of safe haven. Everything has been so highly correlated that there have really only been two places to hide, so to speak: gold and U.S. Treasurys. As a result, Treasury yields have plunged to historic lows, but there are other options out there.

One of the areas where we find some really compelling value is in corporate bonds and particularly among financial intermediaries, which have gotten hit pretty hard recently. For instance, there’s a very high-profile financial company that’s currently providing almost a 5% yield on five-year paper and puts you on a very steep part of the yield curve, which is really a good place to be.

So we think there are pockets where things are quite attractive, thanks to this re-pricing of risk. And diversification matters. This is why we believe professional management is critically important. Investors are human beings and tend to get more negative from all the negative headlines, which makes it easier to miss those little kernels of opportunity when they're created. We see attractive, selective value in the volatility.

Q: Earlier this year, there were strong concerns about the potential impact of inflation on the fixed income marketplace. There were also worries about increased default risks for municipalities. Are these concerns still there?

Stanek: Certainly particular commodity prices rising earlier this year fueled inflation fears. And while it is worth being concerned about that and paying attention, we've been taking the view all along that it's really wages that are going to drive future inflation rates. And when you look at wages and benefits, they aren't rising. In fact, there is still significant downward pressure on compensation and the high levels of unemployment and under-employment indicate that wages won't rise significantly anytime soon. As such, we believe the outlook for inflation is somewhat benign and reiterate that interest rates could remain lower a lot longer than many expect.

On the municipal side, we have always believed that people who invest with us have a primary objective of preserving capital and wealth. Our job is to protect their wealth so we have always been biased to run only one approach when it comes to municipal bonds, and that's high-quality and intermediate. Going too far out in duration would take on too much interest rate risk, and we simply won’t go too far down in quality. We think that all-weather positioning, if you will, should meet most investors' objectives when it comes to wealth and capital preservation. But, more importantly, it should allow them to participate in the market environment without taking on too much risk.

We have not been in the so-called Meredith Whitney camp, expecting this huge wave of defaults, but we are mindful that we are in a hyper-risk environment and – as the federal, state and local governments strive to balance their budgets – there will be ongoing stress for many municipal credits. Rating downgrades have recently outnumbered upgrades five-to-one in the municipal market and we would expect that to continue. Price declines often accompany downgrades and we are acutely aware of that risk right now. In the long run, the balancing of budgets is really healthy but, in the short run, it takes away from current consumption and makes the slow-growth environment we’re in even worse. States are being forced politically to start balancing their budgets. And they are pushing down that stress to local municipalities. So be careful. Be cautious. Be selective. Stay higher quality, stay intermediate, and be well-diversified. We think these are the safest, wisest ways to continue to participate in the marketplace

Q: On the equity side, corporate earnings have been largely positive for the year so far. Yet stock prices continue to fluctuate. Knowing that investors often follow earnings, this seems counterintuitive. Are stocks in general fairly valued right now?

Langenfeld: I think the main issue with stock price volatility right now is that there are a lot of conflicting data points out there. There's conflicting data across our coverage groups, whether we’re talking about industrial or retail or technology, and there's conflicting data in terms of actual underlying end-market demand, so we’re seeing conflicting action in the stocks. For example, the industrial economy is in pretty good shape and seeing pretty good volume, while the consumer economy has been relatively flat from an end-market standpoint over the last year and a half. Yet if you look at some of the individual stocks within these groups over the last 6–9 months, you've seen much better performance among higher-end retail stocks even though the volumes aren't as good. But you have to factor in the markets for these retailers, their profit margins and their pricing power. On the flip side, individual industrials have had a very difficult go of it recently. This conflicting data leads to investor confusion, skepticism, frustration and, I think, much more willingness to kind of sit back and rely on the macro picture, trading a lot of these groups as a whole as opposed to individual companies.

If the question is whether stocks are attractively valued right now, I think you need to look deeper than the macro picture. Some are calling the current environment a recession, some say we’re in a slow-growth mid-cycle recovery. Whatever the case may be, I think the opportunity does exist out there for high-quality, solid-balance-sheet, good-margin-type stories that I think are very attractive by any number of metrics. The real question is whether the sentiment that has pulled us down can pull us further down. And the answer is absolutely clear. We can see that risk relative to sentiment. But even sitting here in the second week of October, the trends do not support the idea of another recession yet. So I believe the environment is going to continue to create selective opportunities from the market perspective.

Q: Given the current and anticipated environment, is there any particular sector that stands out as having better prospects near-term?

Langenfeld: It really comes down to what you think the economy looks like. If you think the economy is going to get worse and go into recession, that is one view that's going to favor very defensive, high-quality, dividend-paying, yield-producing-type companies. Those may include utilities and consumer staples. But that is just one view of it. If you're like I am, and you believe we are in a slow or no-growth environment, there are plenty of industrials that have been thrown out by investors who hold the macro view that things are slowing. And I think there are companies in the industrial cyclical area that have strong balance sheets. They have strong pricing powers, and they have strong longer-term secular stories behind them. I think those can perform pretty well, not because they're going to be able to significantly grow in a flat economy, but because of the starting points where the stocks are currently, and the ability to get pricing and positive earnings growth in a period where, if we have a flat economy, the S&P will struggle to grow earnings.

Q: We've been hearing for most of this year that U.S. companies – post that shoring-up process that many went through during the recession – are enjoying large cash balance sheets. Is that still the case even after the large downward swings in some stock prices and, if so, what can we expect they might do with that money and when?

Langenfeld: That is absolutely still the case, and we see it across many different sectors. The amount of liquidity in the balance sheets of the main financial companies is still significantly better and in very good shape relative to where we were in '08. So yes, there's a big, big difference relative to where we were. My sense in talking to the executives of the companies that I particularly follow is that they are going to wait. And they have no urgency to put this cash into play until there is more certainty both to the political landscape and where the direction of decision-making is going. And I think even that is even above and beyond the economy. It'd be one thing to say, “Okay, look, we're in an economic recession that will take a while to cycle out of it.” It's another thing to have that hanging over us, plus the indecision of what the long-term regulatory environment looks like.

So I don't get a good sense beyond the one place where we have seen cash continue to flow: the capital spending related to many of the temporary tax-relief efforts designed to get companies to take advantage of that expensing of capital. That is helping. But, beyond that, and they're not willing to come together in general, I would suggest they're not willing to broadly invest in more risky or more longer-term-type projects that haven't already been in their queues.

Q: Wild market swings in August triggered some common reactions in investors. Some made dramatic reallocations within their portfolios, while others took their money off the table entirely. Understanding that we are likely to see continued volatility going forward, what can investors do to help insulate their portfolios and manage these risks?

Thurow: The trouble with dramatic changes in allocation is that for most investors, their long-term return objectives have not changed. Any substantial change to their investment allocations in response to emotion or fear caused by volatility will have an impact on their ability to meet their long-term needs. That would be the first and foremost concern to keep in mind. The other thing to be very aware of is that trying to time the market is extremely challenging. The reality is, if you make a major re-allocation based on market conditions, in order to benefit you have to be right twice – once regarding when to get out of an investment, and then again regarding when to get back in. What many people forget is that volatile markets are volatile in both directions. They can swing up and down and both can be dramatic. So the risk is, even if you substantially shift the weight of your allocation and get it exactly right on the downside, you could easily miss any or all of the rebound when the market comes back, which can happen very, very quickly.

All of that said, I think it's very appropriate for some investors to make modest reallocations in the current environment or maybe even allocate a portion of their portfolios to something with a more flexible investment mandate. This enables a piece of that portfolio to be more nimble and take advantage of tactical opportunities that arise in volatile environments. But again, we'd recommend that be a portion of the allocation as opposed to a wholesale shift.

Of course I agree with Mary Ellen that diversification and asset allocation are important – perhaps even more important today than they have been traditionally. There is a companion article in this quarter’s issue of Investment Digest that goes into deeper detail regarding the ways in which asset allocation strategies have evolved, and I recommend that any investor with concerns about volatility and increased correlation in today’s markets take a close look at that.

Q: In the fixed income environment that Mary Ellen describes, a fair number of our clients are feeling the squeeze on income from their investments. Are there alternatives that they should be considering right now?

Thurow: There can be. Low interest rates mean lower income on yields for all types of investments, and we’re certainly below-average income or yield relative to historical norms. So, barring a change in expectations, in many cases investors will have to try different asset classes or different security types to meet their same income demands.

As we all know, though, anything that brings potential for slightly higher yield can bring with it higher risk. So being very careful in that approach, being very selective, being diversified and staying high-quality, as Mary Ellen mentioned, is something that really applies broadly here as well. On the fixed income side, invest in investment-grade securities versus just Treasurys, global bonds as opposed to just domestic bonds, to take away some of the correlation or dependence on U.S. interest rates.

But in all cases, we recommend taking a diversified approach in terms of using different asset classes and therefore different security types as opposed to putting all your eggs in one basket. And certainly the help of a financial advisor can make a difference. It's really important to have someone help navigate that potential trade-off between higher income yield potential and more risk.

Bittles: Both Laura and Mary Ellen have touched on this, but asset allocation is really the only way you can operate in an environment like this, and to use asset allocation to maneuver. There are two risks in market timing. One is being out, and one is being in. And I'm going to bring up being out right here, because there is a possibility this market may have made a bottom. And if it did, it was evident in the psychology of the market – investor psychology – which I think really controls most of the market’s. Pessimism has been about as thick as it ever gets, and that suggests that a lot of cash has been piling up on the sidelines that could support a rally.

The bottom line is, nobody knows where these markets are going to go. Our job, as Mary Ellen said, is to be risk managers. And that's how we operate in our ETF portfolios. And while I think it's a high-risk environment here, you have to be open-minded. The market could also go up, despite the fact that there's a lot of negativity out there. Earlier Jon talked about valuations, and I don't really look at valuations all that much. But right now, I'd say with the recent decline in the market, valuations are at least normal. By that I mean the market’s probably not currently over-valued or under-valued.

Also I would say I do a lot of client events around the country for Baird, and without a doubt, the mindset of our clients is that they're not so interested in the upside as they are in preserving their principal. They've gone through the 2001 and 2002 bear market, the 2008–2009 bear market. The stock market today is the same place it was in 1998. They just don't want to lose what they have. And that suggests to me that this environment is not perhaps as risky as we all might think. If everyone was bullish here to the extreme, I would really be very concerned. But perhaps we're going to get a break here.

If the election goes in a fashion that favors the business environment, then I think that would be a big step forward for next year and help prevent something really terrible happening in the markets. Now I think next year for the economy is going to be very challenging. But if we're going to get a change in Washington, the markets are forward-looking. And they'll overlook that the economy is not doing so well.

So we may come out of this in pretty decent shape, although we have to guard against the possibility of an unexpected event. Now in a slow-growth economy, that's the problem. You're vulnerable to an unexpected event. And therefore you have to guard against that. You do with asset allocation. I think right now we've got our clients 50–55% in stocks; the rest in bonds and cash, some gold. And I think that's the way you navigate through these high-risk times.

Thurow: Another way we are recommending that people can handle the current market volatility, both in equity and fixed income, is to consider whether allocating a portion of their portfolios to alternative investments might be appropriate. Really the key there is that there is little to no correlation. In a slow-growth environment, the economy and the markets are susceptible to shocks. But alternative investments can be a portion of the portfolio that has a low correlation to all of that. Now, here too, it's important to know what you own. Take a conservative approach. We certainly wouldn't think of alternative investments as a return enhancer, but more a risk mitigator. And even within that allocation, taking a multi-manager, multi-strategy approach, that's a way to mitigate and navigate some of the volatility and smooth things out a bit.

Stanek: On the subject of remaining careful and conservative, I think asset allocation is key. But I will also tell you that, as a professional investor for over 30 years, every time I have tried to create an opportunity that the market wasn't giving us, I usually regretted it. The point being that investors do need to manage their own expectations in times like these and be realistic.

We’ve talked about risk management being the essence of investment management. That involves downside protection and managing expectations on the upside too. Just understand the risks you truly are taking, and ask yourself if you are being paid enough to take those risks. Is what you’re doing consistent with your long-term objectives. Most importantly, just be mindful of the environment we’re in.