How best to ride the gloom and doom...

Now that most of the world is experiencing the effects of an economic contraction and considering that most of the more recent economic data are strongly suggesting that the recession will probably last beyond 2009, the question that comes to mind is how best to structure one's portfolio in order to most effectively ride the gloomy patch?

Taking a portfolio structured along three core asset classes (fixed income, equities and alternatives) and beginning with fixed income, my first suggestion would be to make sure that the exposure is diversified. This is in sharp contrast to last year's risk laden environment of "across the board" market corrections where the most effective strategy for fixed income turned out to be concentration in a single subset of the asset class, namely "treasury" type securities. The dramatic increase in risk averseness last year effectively punished all fixed income instruments outside those issued by governments. This means that today we observe spreads in other categories such as corporates, high yields and emerging market debt that are at levels comparable to those seen couple of years ago. Add to this that treasury type debt are probably not only overpriced (reflecting the acute risk averseness) but that we need to factor in all the additional supply that is likely to hit the markets in order to pay for the present and future "bailouts" and it quickly becomes clearer why maintaining a concentrated portfolio would be perceived as a highly risky proposition.
For equities a "sector rotation" approach is in order. Whereas a "defensive" play was most suitable for last year's "we are entering a recession" environment, and is probably still the case for at least part of this year, an eventual rotation back to "cyclicals" probably towards the end of the year would seem logical. Obviously this would depend on how the economy unfolds but we have to remember and factor in the "forward looking" nature of stock markets (a market rebound typically precedes that of the economy sometimes by several quarters).
As for alternatives, lots of caution would be advised in the hedge fund space. This is a segment that is likely to experience a high degree of consolidation as the less talented players are squeezed out, and as it becomes increasingly difficult for event the better ones to secure operating income. Private equity may also experience consolidation for similar reasons. The real estate market could, on the other hand, become attractive again, albeit in a highly selective way. Let us not forget commodities (a cyclical play) which should continue to provide excellent long term opportunities, especially after the huge correction.
Finally, we need to consider the aftermath repercussions of the stimulus plans that are being implemented pretty much across the globe. At this stage it is difficult to say whether they are potent enough to eventually trigger inflation. It will depend on many factors such as if the monetary authorities will react early enough or how much further housing prices need to drop before we reach a bottom. It is nevertheless prudent to provide some sort of hedge against the risk of both inflation and deflation. Exposure into such things as Treasury Inflation Protected Securities (TIPS) or gold (gold also being a good hedge against a weakening dollar) would help on the inflation side. Maintaining some exposure into treasuries would ensure at least some protection in the event of deflation.
One last word of advice would be to avoid looking too frequently at the markets, there is so much noise out there that it would serve no other purpose than to confuse and that is the last thing you need right now!