Last week, Fed Chairman Alan Greenspan delivered one of his most stern warnings yet on the health of the U.S. financial system. His biggest concern seems to be the increasing amount of risk investors are willing to take, even though returns are likely to be muted. “Any onset of increased investor caution could cause housing and stock prices to drop and force investors to liquidate assets to repay debts. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums,” he said.

An apt translation of Greenspan’s comment? “In a rising rate environment, there is little margin for error.” If something goes awry–another terrorist attack, or weaker earnings, or an inverted yield curve–the stock market is much more likely to take it on the chin.

Last month’s market action is a case in point. A number of exogenous factors, including a dramatic spike in crude oil prices, caused stocks to give up a big chunk of July’s impressive gains. This occurred even though market fundamentals–including earnings, economic growth, and corporate balance sheets–are improving.

If the other shoe does indeed drop, the amount of pain felt by investors will be largely dependent on the willingness of the Fed to inject liquidity in the banking system. This strategy has been successfully used to avoid follow-through from a number of market shocks. Considering the current hawkish view of the Fed, though, the odds that rates would be lowered due to an exogenous event is not as high as in other periods.

Even so, the best defense is a modest allocation to fixed-income securities. Bonds tend to rise when equity volatility spikes, and provides important diversification during periods of adverse price moves. I suggest a modest allocation to a fund benchmarked to the Lehman Aggregate bond index. Such products have a yield just under 4%, and at the same time will not suffer in price if long-term rates continue to increase.

The Monthly Index Report for September 2005

Index Aug-05 QTD YTD Description
S&P 500 Index* -1.12% 2.44% 0.69% Large-cap stocks
DJIA* -1.50% 2.01% -2.80% Large-cap stocks
Nasdaq Comp.* -1.50% 4.63% -1.07% Large-cap tech stocks
Russell 1000 Growth -1.29% 3.54% 1.75% Large-cap growth stocks
Russell 1000 Value -0.43% 2.45% 4.25% Large-cap value stocks
Russell 2000 Growth -1.41% 5.48% 1.70% Small-cap growth stocks
Russell 2000 Value -2.30% 3.26% 4.19% Small-cap value stocks
EAFE 2.56% 6.35% 4.81% Europe, Australasia & Far East Index
Lehman Aggregate 1.28% 0.36% 2.88% U.S. Government Bonds
Lehman High Yield 0.19% 1.94% 3.07% High Yield Corporate Bonds
Calyon Financial Barclay Index** -0.12% -0.32% -0.26% Managed Futures
3-month Treasury Bill 1.83%
All returns are estimates as of August 31, 2005. *Return numbers do not include dividends. ** Returns are estimates as of August 30, 2005