How I'm going to play my 2007 forecast...

In response to yesterday's column on mt 2007 forecast, one reader asked the following:

Could you also make a recommendation as how to play these scenarios vis-a-vis "most likely" vs. "possible "

Good question. The whole reason why I think about "most likely" vs. "possible" is because I accept that the world economy is extremely dynamic, and for anyone to claim that they have good visibility on how the economy is going to look in a year's time is kidding themselves. So I break down my thinking on the economy into possibilities and probabilities. I wrote a post on this concept back in September.

So you want to build a portfolio which will perform well in the scenario you think is most likely, but will still perform OK in scenarios you think are fair possibilities. Obviously you can't plan for everything, but one way to do this is to weight your portfolio bets more heavily in areas where both forecasts are consistent. In addition, you avoid making bets that would only perform well in a single scenario, particularly when the payoff isn't so great.

For example, yesterday I predicted that intermediate-term rates were likely to rise. On the other hand, I think that if a recession were to occur, intermediate term rates would fall rapidly. So if I only followed my primary forecast, I'd be short duration. But the risk/reward is actually poor on such a bet. Because I think there is a strong possibility of a small move up in rates, but a smaller possibility of a big move down in rates, the bet is skewed against me. Stay neutral duration.

Now corporate spreads seem likely to widen either way. Maybe a little, maybe a lot. High yield seems poised to perform poorly either way. Maybe a little, maybe a lot. MBS look at least OK in both scenarios. So I'm overweight MBS, avoiding high-yield, and staying in higher-quality corporate names.

I also think the curve steepens either way. I didn't mention this, but I think its possible that if the recession scenario happens, we get a deeper inversion initially. So I'm protecting against this by owning some 30-year paper, but concentrating your positions in the 5-10 year area. I also own a small non-inversion note position, to given me a big pop if my steepener comes through.