The relatively low volatility stock market of the last few years seems a thing of the past. Today we see wild moves almost daily as the market swings from euphoria to panic.

On the one hand, the probability of a deep recession is more likely than it has been in at least the last 25 years; the troubles in housing and credit markets are that serious. This increased doom and gloom means maybe a 5% chance of a depression (a deep recession with say a 10% drop in GDP) instead of the perhaps ‘ordinary’ 1% chance. Even a depression almost certainly won’t be as deep as the last real one over 75 years ago because the government today is such a large force in the economy, both as an employer and big – albeit inefficient - spender. 

On the other hand, investors are skittish and avoiding stocks and that’s usually a good sign (as Powerfund investors know, most fund investors are usually wrong). Trillions of dollars are sitting around in cash. The ICI (Investment Company Institute) just reported total money market mutual fund assets hit $3.5 trillion last week. But despite these inflows, yields are heading down for money market funds. 

Ironically, money market funds become more attractive to investors when yields go down, and less attractive when yield go up. That’s because yields tend to go down when the Federal Reserve is lowering rates because of troubles in the economy, often already reflected in the stock market. Fund investors tend to pile into cash after the market slips, and often miss the move back up in stocks. We’ve historically looked at flows out of stock funds as a positive indicator for future returns in stocks.

Of course, we don’t know exactly when the market will turn back up. We’re coming off an asset bubble of historic proportions in housing, and if we had truly free markets, we’re sure the Dow would be around 10,000 or lower today (with some bank failures no doubt). 

But we don’t have free markets. We have a government that has done everything from issuing checks to almost everybody to lowering interest rates in the face of inflation to taking on bad debt from poorly managed investment banks and other lenders to prevent their collapse. 

We don’t really know how far the government will go. Every time we seem to be getting to levels in the stock market where we would like to increase our stock allocations, the government comes to the rescue and the market is again off the races – at least for a little while.

Another risk to investors today – like the collapsing housing market wasn’t enough – is the benefits of diversification seem to be waning. To a properly diversified investor, the 2000-2002 bear market caused a relatively insignificant decline in their overall portfolio – if that portfolio included foreign bonds and stocks with allocations to real estate funds (or just actual property), small-cap value stocks, emerging market funds, utilities, and natural resource funds – even commodities.

Today investors have learned their lesson. We’ve noticed more money in various fund categories than recent memory.

And with dozens of new ETFs every month, the mutual fund industrial complex is making diversifying your portfolio easier than ever.

But so far in 2008 diversification hasn’t helped much. As of the end of March, all stock fund categories are down except funds that short stocks and real estate sector funds, which are experiencing a small bounce after a destructive 2007.

A sharp downturn in the market does tend to drag all stocks down with it. But what’s happening today is unusual. With so many categories of funds today, there is usually something that is up – or at least not down nearly as much.

Some fund categories that over the last few years have had low correlations to one another include foreign stocks, U.S. large-cap value, U.S. small-cap growth, Japan, emerging markets, and the healthcare sector.  So far this year it’s hard to differentiate between them – all are down within a few percentage points of each other. Even natural resource and precious metals funds, which are among the most uncorrelated to equity markets and have benefited from the commodity boom, have recently started falling.

This later collapse has left some reporters and market commentators scratching their heads. Gold has been called a “store of value” so often that reporters think it’s true. This past week <i>The Wall Street Journal</i> likened gold to U.S. Treasurys, “Investors, opening the books on a new quarter, dived into financial and tech issues and abandoned safe havens such as gold and Treasurys”

To call anything that can fall almost 15% in 10 trading days (as gold recently did) either a store of value or a safe haven shows the insanity prevalent in the late stages of the commodity boom.

What this all means is that today a portfolio that is 70% in stock funds that’s reasonably diversified in different fund categories may exhibit the volatility (relative the S&P 500) of a portfolio 80% in stock funds a few years ago. We fully expect the diversified portfolios to be only slightly less risky than a portfolio comprised of just two holdings: a total U.S. stock and bond index fund. In fact the downside risk will likely be greater. 

We’re still planning on moving from safer bonds to stocks and higher yielding bonds on more disruptions (a.k.a. spine-tingling drops).