The S&P 500 has fallen 9.2% since my last update on April 16. The decline has been driven by a large shift in long-term inflation expectations, which have declined from 2.7% to 2.3% today (as determined by the 30-year spread between treasury rates and 30-year inflation-protected securities, or TIPS). This is consistent with the news coverage surrounding the European debt crisis, which has been raising deflation fears in the markets. As a result, the 10-year treasury yield has fallen from 3.8% to 3.1%. The dollar has risen, gold has been steady and commodities have fallen, all consistent with the global slowdown scenario.

Equities

With the decline in the assumed inflation rate, stocks are pricing in a 6.4% long term return, based on long term trend earnings of $58.40.

This return is below the target return of 6.8%. To produce a 6.8% return for today's assumed level of inflation (which coincides with what the Fed targets, so it's a good equilibrium assumption), you would need to see a S&P 500 level of 945.

Fixed Income

There's not much more fun to be had on the fixed income side of the house.

Unfortunately, everything is overvalued with the exception of long term munis, which are roughly fairly priced. The only way to get excited about bonds right now is to have conviction that we're headed into a deflationary double-dip recession.

I don't have that conviction. I'm more in the camp expecting that we'll stumble through a subpar recovery, with the economy weighed down by deleveraging in the consumer and real estate markets. If I had to put new money to work in the US, I would either keep it safe in cash or short term bonds for deployment later or I would buy stocks out of a lack of better options, where we could see a bit of a rebound as people realize the world isn't relapsing into recession.

The dollar

Major currency index – nominal

The dollar has rallied against the Euro and other major currencies recently, trading to the top of its long-term (downward-trending) trading range. This creates an opportunity to cycle some money out of US fixed income (like corporate debt or TIPS) and into foreign stocks and bonds.

Commodities

I'm not sure what to make of commodities. Commodities, as represented by the CRB futures index, are cheap relative to gold but expensive relative to consumer prices.

For all we know, gold could be overvalued, so I'm not enthusiastic about recommending buying commodities.

Housing

Housing prices are still a bit higher than their long-run, inflation-adjusted equilibrium level of about 100. Given how high prices were away from equilibrium during the boom, and that prices and sales are being actively propped up by the government currently, there is a great danger that prices can overshoot to the downside if the market relapses, which it easily could. My hunch is that commercial real estate is in even worse shape than residential.

Conclusion

Outside of taking advantage of the strong dollar to allocate some money into foreign stocks and bonds, I'm at a loss to get excited about any particular asset class. Not a bad time to take some bond profits and build up some cash. Cash may pay zero percent right now, but that's better than losing money.

This column is written purely for the author's pleasure. I am not a financial advisor. Please consult your own financial advisor before acting on any investment recommendations.