Courtesy of Elliott Wave Int’l, the following chart illustrates a solidified scenario as stocks, oil, precious metals and commodities have all synched up for a continued decline.

As credit continues to contract, these aligned trends should remain intact.

Courtesy of Elliott Wave International, the below chart illustrates the completion of Primary Wave 2 up from March of ’09 with the Dow Jones Industrial Average (DJIA) falling today below the key May ’11 high.

With the break below the May ’11 high, the start of Primary Wave 3 down has started.

Primary Wave 3 down is expected to be longer and deeper than Primary Wave 1 which carried the DJIA from 14,093 on October 8, ’07 to 6,626 on March 2, ’09.

One should expect prices to extend below 6,626 when Primary Wave 3 is completed.

This illustration developed by Edward Jones is a nice reminder of the role played by emotions when it comes to investing.

Stock investors as we know from the study of Socionomics typically are most bullish at market highs and most bearish at market lows.

Astute investors use sentiment factors to make investment decisions and to avoid periods in which investors are most bullish by staying in cash and to invest in stocks when investors are most bearish.

The red arrow is where we are today.

Courtesy of www.zerohedge.com, the following chart reflects the major divergence between stocks represented by the S&P 500 index and the US Data Trend Index represented by macro economic data over the past 3 months.

If we repeat what happened last year then we can expect stocks to fall significantly from their current highs.

Courtesy of Elliott Wave Int’l, this chart illustrates the fall in stocks following the last two bailouts of Greece. It’s clear that once the euphoria for European Central Bankers stepping up to bailout a Euro Zone country wears off, then the reality of the Euro Zone Crisis sets in.

Will this time be different?

Courtesy of John Mauldin, the below balance sheets of China, Europe, U.S. and Japan have expanded in the past 3 years like no other time in history.

As our favorite character from the Honeymooners, Ralph Kramden, love to say…

”TO THE MOON ALICE!”

All this expansion is courtesy of yours truly, Ben Bernanke.

Just this past week, Ben delivered again and did just what  the stock and bond markets wanted, promised to keep the money flowing by keeping interest rates at near zero through 2014.

This is unprecedented.

Then again, everything that Ben has done up until now in the past three years is unprecedented.

How has the one asset class, owned by many Americans, stocks  done over this period. Not too shabby.

But what will Ben do next if stocks start to fall again? Market participants say he’s out of ammunition/options.

Unfortunately, no one knows what will happen.

Ben doesn’t even know. All he knows, he has got to keep printing money.

All the printing and growth really hasn’t come back, inflation is dead, unemployment is still high.

All I know is Ben must still be scared.

How do I know this? Because I spent the last fifteen years of my twenty year career in the financial services industry developing and supporting this same guidance and advice through my roles at AXA Financial, JPMorganChase and Prudential, some of the largest financial services and asset management firms in the industry.

What am I referring to? I am referring to the “asset allocation” guidance and advice that every major financial services firm uses to guide and advise their clients when it comes to determining how much you should allocate to stocks, bonds, and cash.

While the terms supporting asset allocation may seem very technical to you, I’m going to attempt to present some basic scenarios which will help you understand why this type of asset allocation is broken.

The type of asset allocation used across the financial services industry is called strategic asset allocation and is based on a theory called Modern Portfolio Theory (MPT). MPT and the models you see are typically represented by an “expected return” and “risk.”

To create the models, a director of asset allocation usually, the role I had at AXA Financial for eight years, will develop an expected return, risk, and correlation for stocks, bonds, and cash and use an optimization process to determine on a scale of expected risk what mix of stocks, bonds, and cash provides the highest return for a given level of risk.

The return, risk, and correlation on stocks, bonds, and cash are developed from historical returns on these asset classes which commonly date back to 1926. Generally speaking the typical expected return for large company domestic stocks is 10%, small company domestic stocks 12%, bonds 5%, and cash 3%. While the assumed returns are a good reflection of the average returns over last 85 years, the hard reality for aggressive investors that have invested a majority say 90% in stocks over the last 11 years, the return they have received in stocks has been approximately 0%, not !0% or 12%. Is this typical, yes it is in fact if you look at the following chart on secular stock periods you’ll see that stock returns come in the form of cumulative returns over long- periods not average returns.

Bottom line before investing in stocks is you need to know the type of secular market or pattern in stocks you’ll be investing in. Currently we are in a secular bear market that is expected to last another few years. How much do you have allocated to stocks?

One of the central tenets of strategic asset allocation is that by mixing low correlated asset classes with your stock allocation you can reduce portfolio volatility.  In theory, to have the greatest asset allocation benefit from a mix of two asset classes, the asset classes would have a correlation of negative 1.00.  A positive correlation of 1.00 between two asset classes would therefore provide no reduction in portfolio volatility. To understand the realities of asset class correlations, we’ll now look at long-term and short-term correlations during the 2008 financial markets meltdown using four Vanguard mutual funds as proxies for the stock, bond, gold, and natural resource asset classes.

Since 1990 the average twelve month correlations of the Vanguard 500 Index Investor fund (stocks) with the Vanguard Total Bond Market Index fund (bonds), the Vanguard Precious Metals fund (gold), and the Vanguard Energy fund (natural resources) were as follows…

• Stocks & Bonds: 0.11…therefore if stocks fell 10% over the period, then bonds would fall 1.1%.
• Stocks & Gold: 0.32…if stocks fell 10%, then gold would fall 3.2%.
• Stocks & Natural Resources: 0.53…if stocks fell 10%, then natural resources would fall 5.3%.

Mixing stocks with bonds therefore appears to provide you the greatest asset allocation benefit in reducing volatility over long-term periods.  

However, the real world asset allocation dynamics during the ‘08 financial markets meltdown were much more variable.  Between Sept. and Oct. of ’08, correlations
spiked, asset classes moved down in sync, diversification failed, and strategic asset allocation portfolios dropped more than expected.  Specifically, the correlation between the Vanguard 500 Index Investor fund and the Vanguard Total Bond Market Index fund jumped from negative 0.63 in Sept. to positive 0.43 in Oct. and 0.34 in Nov.  Gold, the one asset class which in the past provided a safe haven during stock market downturns, also became highly correlated with stocks.  The correlation between the Vanguard 500 Index Investor fund and the Vanguard Precious Metals fund whipsawed from negative 0.55 in Aug. to positive 0.79 in Sept. and 0.90 in Oct.  The correlations with raw gold prices and the Vanguard S&P 500 Index fund also swung from negative 0.82 in Aug. to positive 0.14 and 0.57 in Sept. and Oct.  As for commodities, the correlation between the Vanguard 500 Index Investor fund and the Vanguard Energy fund increased from 0.51 in Aug. to 0.60 and 0.73 in Sept. and Oct.

To illustrate how all asset classes dropped in sync, the following table details the monthly returns in asset class prices during this critical period.

Month to month correlations between stocks and other asset classes can vary widely and increase significantly during a financial crisis.  The only panacea to protect your assets during a financial market meltdown in which stocks, bonds, gold, and natural resources are falling together is an allocation to the cash asset class.

Lastly, the reality for most investors is that when they consider risk they think of the absolute losses of an investment as we did above. There is solid academic research to support this behavior. Unfortunately the “risk” of the asset allocation model provided by financial services firms is the standard deviation of a normal distribution or variability of returns. This is flawed. The fact is the standard deviation of a normal distribution measures just 68.2% of the monthly historical return occurrences representing the asset allocation model. The major unfortunate characteristic of the standard deviation of a
normal distribution is that losses (and gains) that fall outside 68.2% are not even considered. Some of these losses which are referred to as “fat tails” can be significant and if repeated in the future can decimate a portfolio and the client’s assets that are allocated to it. Additionally, academic research on fractals supports the fact that “fat tails” in securities occur more often than what is commonly perceived by investors. The harsh reality is the asset allocation models do not consider nor present to the investor the potential “fat tail” or extreme loss in using the asset allocation model strategy.

In the fall of ’08 and winter of ’09, I became acutely aware of these flaws as a portfolio manager across six strategic asset allocation portfolios with approximately $30 billion assets and a 401k participant having lost approximately 45% of my investable assets due to high allocations to stocks.

As a result I decided to develop a new asset allocation approach and strategy for my retirement assets. I call it Asset Allocation For All Markets, to learn more go to the following links:

• Growth & Protection Factors
• Stock Factors & Methodology

There’s a great new book out by the Nobel Laureate Daniel Kahneman about the mind and how humans think. A major point of the book is that humans need for an explanation to just about everything can regularly lead to people jumping to the wrong conclusions. On Wednesday the consensus among market commentators was that stocks went up because the central banks of the world are now prepared to put an end to the Euro Crisis. Based on the following chart courtesy of Elliott Wave Int’l, stock investors should be scared about subsequent stock returns when central banks act together.

Courtesy of Goldman Sachs…

One of the central tenets of asset allocation is that by mixing low correlated asset classes with your stock allocation you can reduce portfolio volatility.  In theory, to have the greatest asset allocation benefit from a mix of two asset classes,  the asset classes would have a correlation of negative 1.00.  A positive correlation of 1.00 between two asset classes would therefore provide no reduction in portfolio volatility.  To understand the realities of asset class correlations, we’ll now look at long-term and short-term correlations during the 2008 financial markets meltdown using four Vanguard mutual funds as proxies for the stock, bond, gold, and commodity asset classes.

Since 1990 the average twelve month correlations of the Vanguard 500 Index Investor fund (stocks) with the Vanguard Total Bond Market Index fund (bonds), the Vanguard Precious Metals fund (gold), and the Vanguard Energy fund (commodities) were as follows…

• Stocks & Bonds: 0.11…therefore if stocks fell 10% over the period, then bonds would fall 1.1%.
• Stocks & Gold: 0.32…if stocks fell 10%, then gold would fall 3.2%.
• Stocks & Commodities: 0.53…if stocks fell 10%, then commodities would fall 5.3%.

Mixing stocks with bonds therefore appears to provide you the greatest asset allocation benefit in reducing volatility over long-term periods.

However, the real world asset allocation dynamics during the ‘08 financial markets meltdown were much more variable.  Between Sept. and Oct. of ’08, correlations
spiked, asset classes moved down in sync, diversification failed, and strategic
asset allocation portfolios dropped more than expected.  Specifically, the correlation between the Vanguard 500 Index Investor fund and the Vanguard Total Bond Market Index fund jumped from negative 0.63 in Sept. to positive 0.43 in Oct. and 0.34 in Nov.  Gold, the one asset class which in the past provided a safe haven during stock market
downturns, also became highly correlated with stocks.  The correlation between the Vanguard 500 Index Investor fund and the Vanguard Precious Metals fund whipsawed from negative 0.55 in Aug. to positive 0.79 in Sept. and 0.90 in Oct.  The correlations with raw gold prices and the Vanguard S&P 500 Index fund also swung from negative 0.82 in Aug. to positive 0.14 and 0.57 in Sept. and Oct.  As for commodities, the correlation between the Vanguard 500 Index Investor fund and the Vanguard Energy fund increased from 0.51 in Aug. to 0.60 and 0.73 in Sept. and Oct.

To illustrate how all asset classes dropped in sync, the following table details the monthly returns in asset class prices during this critical period.

Bottom Line: Month to month correlations between stocks and other asset classes can vary widely and increase significantly during a financial crisis.  The only panacea to protect your assets during a financial market meltdown in which stocks, bonds, gold, and commodities are falling together is an allocation to the cash asset class.