As our first chart below reminds, the trend in jobless claims continues to deteriorate, which is to say that the population of the unemployed is still expanding. Last week new filings rose to 455,000, the highest since 2002.

The news isn't any better for the ranks of the formerly employed who continue collecting unemployment checks. As the second graph below illustrates, continuing jobless claims jumped again for the week through July 26 to 3.311 million, an elevation that hasn't been seen since 2003.

The two trends are hardly surprising, given the broader perspective on the weakening economy, as we discussed yesterday. Expected or not, today's news for the job market will provide another jolt of bearish realism to those who think that a rebound from recent ills is imminent.

The economic weakening will get better before it gets worse, in other words. That doesn't mean the pain will get materially worse, although no one should rule out the possibility. But the general trend, at least, is clear. Only the duration and magnitude are in question.

The black line in the chart above, which runs through June 2008, is our broad measure of U.S. economic activity, comprised of 17 variables, ranging from nonfarm payrolls to retail sales to business loans. The index's biggest weighting (a bit more than 40%) is comprised of leading indicators, which are those measures (such as new building permits and disposable personal income) of economic activity that are considered as windows into the future. Another 30% of our broad economic index is made up of coincident indicators with the remaining 30% in lagging indicators. In short, the CS Economic Index is designed to measure broad economic activity, giving a modest bias to leading indicators.

With that in mind, we take no comfort from the relatively sharp decline in the leading component of our index (the red line in the chart above). As you can see from the graph, the leading indicators are signaling that there are more challenges ahead. In fact, the leading indicators have been flashing warning signs for some time now, although the downside momentum has only been bubbling since late last year.

As for our economic index's forecast, keep in mind that's its insight into the morrow, such as it is, is mostly speculation and therefore subject to change. Ours is an intelligently designed measure of broad U.S. economic activity, or so we believe. And while it factors in so-called leading measures of economic activity into the mix, we have no illusions about the true value of our index: clarifying the past. As for the future, we can only guess. Crunching economic numbers, no matter how you slice it, is first and foremost a venture of looking into the past. Nothing wrong with that; in fact, it's quite valuable for context and so we highly recommend the sport. The key is remembering that it's no substitute for a crystal ball.

At some point the economy will heal, and the rebound will take root. Perhaps the leading indicators will give us an early sign of the approaching bounce, perhaps not. The odds are probably stacked against us for correctly divining the future with any precision as to timing, in part because the full range of economic numbers arrive with a considerable lag. Even if the data was dispensed in real time, that still wouldn't change the fact that economic reports are mostly about the past.

That doesn't stop us from trying to peer into the future, but we do so with the full recognition that our vision is heavily clouded. So it goes when swimming in the murky waters of the dismal science.

The first order of business in digesting today's report on personal income and outlays is looking at the big negative: disposable personal income dropped by a hefty 1.9% (seasonally adjusted) in June. This is income that's left over after Joe Sixpack has paid his bills and so it's a key number about his capacity for running to the mall and picking up an extra TV. In short, this is the front line measure of the American economy's growth potential. GDP, after all, is overwhelmingly dependent on consumer spending. As such, the 1.9% drop in DPI--the first slump since April 2007 and the biggest decline since August 2005--looks ominous, as our chart below suggests.

But the DPI drop isn't quite as painful as it appears. Note in the chart above the large bump in May that precedes June's drop. The rise in DPI is courtesy of the government's stimulus checks. The stimulus is temporary, of course, and so its effects are beginning to fade. No great surprise. If we take out the anomalous jump in May's DPI, June's level of DPI is at an all-time high.

The key issue is deciding how much additional DPI fading awaits. Logic suggests we'll return to trend, short of another round of stimulus. By that reckoning, DPI will fall in the coming months, perhaps to the $10.6 trillion level for August or September. That not-unreasonable assumption means that the market has to brace itself for more red ink on the DPI ledger. Such declines will look troubling, but they won't signal much more than the aging effects of stimulus checks. Up to a point, that is. Indeed, one might reasonably think that DPI is due for some additional retrenching due to the various economic ills of late. In that case, DPI declines may run on for longer than the optimists expect.

So much for income. Let's turn to spending. As the above chart illustrates, personal consumption expenditures continue to climb. In June, PCE rose 0.6%. That's down from May's 0.8% rise, but it's clear that Joe Sixpack was still spending at a strong pace in June, at least in nominal terms. Indeed, a 0.6% jump in PCE isn't too shabby, as they say.

But let's not think that all's well. The durable goods component of PCE took a hit big hit in June, falling 1.5%. This cyclically sensitive measure of consumer spending offers evidence that Joe is in fact feeling stressed and he's responding by avoiding purchases of big-ticket items, such as appliances. Looks like buying an extra TV will have to wait after all.

And there's more bad news on spending if we look at PCE in inflation-adjusted terms. By that measure, spending slumped by 2.6% in real dollars in June. Inflation, in short, continues to take its toll.

Overall, let's be clear: the economy faces more challenges. For the balance of the year, and perhaps deep into 2009, strategic-minded investors will be tested by more than a little. That raises the possibility of more investor-friendly valuations in asset classes, although the price of entry will be remaining calm as a bearish aura swirls about.

For now, the economic numbers are surprisingly decent, or at least less threatening than we expected given the backdrop. But the data will get worse before it gets better.

Let's begin by noting that the big stumble last month came in commodities. The DJ-AIG Commodity Index, for instance, dropped by an astonishing 11.9% in July. That's the biggest month setback for the benchmark, as far as we can tell, based on records we can dig up going back to 1991. (Our ETF proxy in our table fared even worse, slipping more than 12% last month.)

Foreign stocks took it on the chin last month, too, although the pain was modest by comparison with commodities.

In the winner's column: REITs, which rebounded in July with a robust gain. Overall, we can say that REITs popped and commodities flopped.

The steep tumble in commodities was due mostly to oil's sharp drop last month. Since most commodities indices are heavily weighted in oil and energy, it's no surprise to learn that commodity benchmarks overall suffered in July. Unexpected? Hardly. Commodities generally have been rallying for years and the corrections along the way, at least on a monthly basis, have been relatively rare and quite mild for the most part. Taking some of the froth out of prices, particularly in oil, is long overdue and it wouldn't surprise us to see more of the same in the months ahead. Commodities generally are a volatile asset class, and if you factor that in with the record prices for many raw materials of late, it's no surprise to see downside volatility has finally come a-courtin'.

At the end of 2001, GMPI was set with a 17% commodity weighting, based on the total dollar value traded for the components of the Goldman Sachs Commodity Index. Since then, an all-time commodity-weight high for GMPI was reached in June, at 28%. Last month, thanks to the sharp correction in commodity prices, the asset class's weight in GMPI dropped to about 26%. That's still fairly high, and so future corrections can't be ruled out.

But let's step back and consider the bigger picture. As the table above shows, GMPI for the past year is still down only marginally, by less than 1%. That's impressive if you consider that U.S. stocks are off by more than 10% for the same period. Yes, it's now clear that we should have all owned TIPS and foreign developed market bonds exclusively over the past 12 months. But such valuable information wasn't obvious 12 months ago, just as the big winners and losers for the next 12 months are largely unknowable in the here and now. As such, owning a bit of everything in some informed blend is the next best thing.

The lesson, once more, is that owning a proxy of the world's major exchange-listed asset classes serves investors well over time. That doesn't mean that GMPI is immune to bouts of volatility from time to time, as July reminds. But in the long run, we're confident that diversification will continue to serve strategic-minded investors well. Even after last month, the concept has held up impressively. All the more so if you consider that implementing the strategy costs less than 50 basis points (via ETFs) and requires no trading skills.

At the very least, GMPI or something equivalent is the ideal benchmark from which every strategic-minded investor can begin to analyze and construct a portfolio. Yes, there are reasons to consider changing this benchmark portfolio to suit your particular investment and risk requirements. But we should do so cautiously, and only when we're supremely confident that our adjustments have a decent chance of paying off. Indeed, beating the market--i.e., something that's close to a representative sampling of the true market portfolio--is still tough, and always will be. A monthly snapshot here or there may suggest otherwise, but for most of us our investment horizon isn't measured in single months and so we can't afford to get caught up in the trend du jour.

As a result, when we see performance outliers--both up and down--in monthly GMPI numbers, we should take it with a grain of salt. Ours is a long distance challenge, and monthly returns are a tiny--a very tiny--piece of generating financial success. Yes, we should routinely monitor the markets, and our portfolios, if only to understand what's happening. But let's be careful not to get frightened by volatility cycles, particularly when they're in full bloom, as they are now.

In fact, let's remain opportunistic when volatility comes to town. Extreme volatility breeds higher-than-average rebalancing opportunities if you're looking several years out.

The proverbial glass, in sum, isn't half empty--it's half full. Volatility is our friend in the long run, if only we can keep our emotions in check in the short run and take advantage of Mr. Market's deals as they emerge. Easy to say, tough to do. Nonetheless, that's still the best deal in town.

Today's release of the "advance" number for second-quarter GDP shows that the economy rose by a real annualized 1.9% pace in the three months through June. That's up sharply from the 0.9% rate in Q1. Is it time to break out the champagne and declare the slowdown over? No, not even close. The correcting and cleansing process for the economy has only just begun.

Our reasoning starts with the observation that Q1's 1.9% jump, while better than the previous number, is mediocre, at best, in the context of the last several years. More importantly, a closer look at the catalysts for Q2's rise raises questions about the future.

A key contributor to the latest GDP rise comes from consumer spending, which rose 1.5% in Q2. That's up from 0.9% previously. Good news, right? Yes, although one has to wonder how much of this is related to the stimulus checks that have been mailed out since May. Stimulus payments are a one-time boost and so they won't be juicing the economy forever. When the charm wears off, consumers will be left to spend their own money. The question is: how optimistic will consumers be from here on out?

Meanwhile, take note that most of the rise in consumer spending in Q2 comes from increased purchases in nondurable goods while spending on cyclically sensitive durable goods dropped sharply. Not an encouraging sign. Indeed, the 3.0% decline in durable goods spending in the previous quarter follows the 4.3% drop in Q1. Back-to-back drops like this are rare for durable goods, and so the trend suggests more trouble on the consumer front.

Speaking of international trade, keep in mind that imports dropped sharply in Q2--down 6.6% for the quarter. That's one of the biggest declines in years. The fall boosts top-line GDP and so statistically speaking the lower level of imports is a technical plus for economic growth. But make no mistake: imports are down because the economy is weak. Falling imports help raise GDP, but no one should assume that the trend is healthy.

What worries us even more is today's weekly jobless claims update. Last week, new filings for unemployment benefits rose to 448,000, as our chart below shows. That's the highest in five years (if we ignore the one-time spike from Hurricane Katrina in 2005). Alas, this trend seems to be building a head of steam, and the implications for consumer spending aren't pretty.

Job destruction, in short, rolls on, or so it appears. We won't know the broader details until tomorrow, when the July employment report is released. Based on today's jobless claims numbers, however, we'll continue to keep the champagne on ice for a bit longer.

Adjusting the 10-year Treasury yield by consumer price inflation tells us what we already know: money is loose, and by design. The Federal Reserve has been intentionally pumping liquidity into the economy to cure the various ills that hound the American business machine. But with the real (inflation adjusted) 10-year yield plumbing depths rarely seen, it's time to ask (again) what it all means.

As the chart above illustrates, the CPI-adjusted 10-year yield dropped to -0.8% in June. That's the lowest negative real yield for the benchmark Treasury since 1980. Using last night's closing 4.09% yield and June's 4.9% 12-month CPI change, we remain at roughly -0.8%.

What does it imply? That depends on your expectations. It could mean that we're giving inflation the fuel it needs to take deeper root in coming years. Or, it mean be just the ticket to temper the economic contraction that's set to get worse.

No one really knows which scenario is coming. Rather than attempt the impossible, let's review how we're calculating real Treasury yields to gain a bit of perspective of where we've been and where we may be going.

For the chart above, we begin with the monthly average for the constant maturity for the 10-year Treasury, as per the St. Louis Fed. We then adjust that monthly number by the comparable 12-month trailing change in CPI, as reported by the Bureau of Labor Statistics.

Perhaps, then, the primary question in the search for real yields is whether we should use headline or core inflation? Here's where number selection makes a huge difference in results. For example, if we adjust the 10-year yield by the 12-month change in core CPI, the real 10-year yield is 1.7% as of June. That's a bit low relative to recent history, although it's hardly abnormal. It's also a world above the -0.8% we get when using headline inflation.

The subject of whether headline or core inflation is a better measure of inflation is a contentious one these days, as we've discussed many times over the years, including here and here. The core vs. headline debate boils down to expectations, namely: if oil and energy prices (i.e., the prices excluded from headline inflation) are set for a secular rise, the value of using core inflation will mislead and misinform. On the other hand, if oil and food prices remain true to their history and continue to cycle up and down sans trend, core inflation will remain the better predictor of future inflation, as it has in the past.

But let's stay agnostic on the question for now and consider the headline-adjusted 10-year yield on its face. That leaves us to ponder the meaning of the extreme depths of real Treasury yields. For our money, we take this as a pivotal moment in the interest rate cycle. If real yields continue falling, we may be looking at a whole new ball game of liquidity injections, the likes of which haven't been seen since the 1970s. That suggests higher inflation.

Does that outlook mean, then, that the Fed will be compelled to tighten? An op-ed by Harvard economics professor Ken Rogoff, published in today's Financial Times, suggest as much: "Is it not now clear that the main macroeconomic challenges facing the world today are an excess demand for commodities and an excess supply of financial services?," he asks. "If so, then it is time to stop pump-priming aggregate demand while blocking consolidation and restructuring of the financial system."

Nonetheless, Fed funds futures traders don't smell a rate hike coming any time soon, as per current prices via CBOT. Perhaps by the end of the year the Fed will raise rates by a modest 25 basis points, the futures market suggests.

Meantime, there's still an abundance of uncertainty about what comes next. Given the volatility and surprises that have become the norm in so many corners of finance and economics, handicapping the future is getting tougher by the day. Nonetheless, it seems like we're about to enter a new phase in the global economic cycle. Alas, we don't have a good sense of what exactly this new phase will bring.

A growing list of index vendors answer in the affirmative. Indeed, the last few years have witnessed an explosion of new benchmarks, many claiming the title of "new and improved" in one sense or another. Alas, it's too soon to make definitive judgments one way or the other, but that doesn't mean we can't consider the strategic possibilities.

In the latest issue of Wealth Manager, your correspondent did just that. The question before the house: What, if anything, can new indices bring to the asset allocation table? For some thoughts on possible answers, read on…

The basic argument goes like this: finance has been relatively unregulated over the past generation, in contrast to the 50 or so years following the Great Depression, when the first round of government oversight befell Wall Street. Lessening the regulatory strings that bound is at the heart of the current ills. The solution: ratchet up government regulation, just like in the old days, a decision that will inoculate the economy from similar bouts of trouble in the future.

Undoubtedly, some reordering of regulatory powers is in order. The fact that the government had to step in and bail out Bear Stearns, Freddie and Fannie and lesser names suggests that something's amiss. But let's be clear: rethinking regulation isn't the same as creating more regulation. And even the most-intelligent regulatory notions will come at a price.

New government regulations, no matter how well meaning or deftly conceived will spawn unintended consequences. History is clear on this point, as it's been proven time and time again. Market forces are always with us. Governments are inclined to suppress and re-engineer those forces to satisfy political demands. That's all well and good, and in a republic the crowd's demands, within reason, must be addressed. Still, the basic inspiration for action on this front is invariably one of manufacturing a free lunch of one sort or another. But there is no free lunch. Of course, that piece of information tends to be overlooked at the dawn of a new age of regulation.

Regulation is more subtle than taxes as a tool of market intervention. New rules of operation may impose additional costs of doing business, or they may equate with higher opportunity costs. Meanwhile, the efficacy of new regulations may not be obvious. A new financial structure that's designed to prevent corporate implosions a la Bear Stearns will, if effective, create the appearance of normality. In other words, regulation often seeks to prevent certain outcomes--bankruptcy, for instance--as opposed to creating events that might not otherwise happen, such as redistributing wealth. As such, regulation may be a covert force, impacting free markets in a way that's overlooked by the crowd.

The best case scenario is when regulation works quietly and produces a social good that's generally applauded as progress. But there are unintended consequences to consider, too. The fact that such consequences are "unintended" means that they're not obvious in advance. All the more so in an economy that's already regulated every which way. The prospect of identifying cause and effect has gone the way of the dodo as a practical matter in economic analysis.

Perhaps the mother of all unintended consequences is unfolding now, thanks to the grand plan in recent decades at engineering recessions out of existence. For 20 years or so, the so-called Great Moderation has been a success, or so it seemed. But a victory based on suppressing market forces is by definition a temporary victory, as we've discussed.

The idea that you can trim or eliminate economic contraction without materially affecting growth, or creating dangerous unintended consequences elsewhere in the economy is a popular myth. That's not to say that market forces should always and forever have the last word. But if we're wedded to the idea of some degree of government intervention to tame market forces, we must also recognize that the task will come at a price--eventually.

That leads us to assess the current dilemma, including the cries that unfettered market forces as the source of the financial and economic pain. First, we need to recognize that market forces, by their nature, are a volatile lot and in the short term there will be pain. Joseph Schumpeter, among others, made this clear long ago. In exchange for short term pain, however, is the prospect of long-term gain that, in the aggregate ends, produces a net plus for the economy overall. In the meantime, market forces will naturally and inevitably produce pain in one corner of the economy on an ongoing basis. Growth, after all, requires innovation, and innovation is by nature experimental, and experiments sometime stumble. Is that a sign of market failure? Absolutely not.

Let's also recognize that the broad efforts at promoting the Great Moderation have probably exacerbated the pain by promoting 20 years of borrowing and risk taking that might not otherwise have occurred if recessions weren't tamed. By pushing the payback into the future, the accumulated price tag has grown, and is now coming due, with interest.

No, we're not arguing that our economic policy should return to the 19th century, when booms and busts were dramatically more frequent and severe and government intervention was virtually unknown. The dismal science has learned much over the years and there's no reason to think that an intelligent management of the economy can yield benefits, or at least minimize the pain. But there's a limit to the benefits that can be extracted from market cycle management, and we may have reached those limits.

Conceptually, an intelligent economic policy will seek a) to maximize the growth that naturally flows from creative destruction; and b) minimize the pain. There are multiple points of equilibrium in that tradeoff, and deciding which point is preferable is a political decision, and an evolving one at that.

Economically speaking, the tradeoff is likely to yield relatively meager results in the next few years, if not the generation ahead. Why? Because the benefits of the past have been unusually big.

What's coming will not be evidence of market failure. Rather, it's the cost of the "free lunch" we've all been enjoying over the past 20 years. So, yes, the bill has arrived and we're being asked to pay. But this time, management is only accepting cash.

Return doesn't lend itself to forecasting, at least not in the short term. But when we look further out in time, there's a bit of transparency at times about what's coming. Meanwhile, risk's a bit more reliable generally when it comes to seeing the future, and that small opportunistic opening gives us a leg up on being completely and utterly subject to Mr. Market's whims.

Shrewdly blending the little intelligence we can gather from the market in terms of risk and return forecasts offers strategic-minded investors the last, best hope for success in portfolio management.

One example: if stocks generally offer a relatively high dividend yield compared with the past, numerous academic studies show that the odds are enhanced for earning higher-than-average returns over the subsequent three to five years and beyond. Mind you, there's no guarantee, but the higher the yield, the better the odds. But we can't rely on this prospect alone, which is why we can't apply this concept to one or two stocks. Instead, we greatly improve our odds of tapping higher-than-average returns by diversifying.

In other words, buying a broad portfolio of stocks at a relatively high dividend yield further increases our chances for beating the buy-and-hold long run performance. Combining the two risk management strategies--buying when yields are high and diversifying the bet--offers more confidence of earning above-average returns than either strategy does in isolation of the other.

We can further enhance our prospective risk-adjusted return by taking the advice above and applying it to multiple asset classes. Once again, we must do so intelligently, by leveraging what we know about risk and it's slightly better odds (compared to pure return forecasts) for extrapolating the past into the future. That is, correlations and volatility matter when considering how to intelligently blend multiple asset classes for above-average results.

If we look to bonds, we know a lot in terms of how they compare to stocks. We don't what the returns of each are going to be, at least not completely, but their relationship tends to be fairly stable over time. One, bonds tend exhibit relatively low standard deviations and correlations compared with equities. Again, that information by itself isn't much help, but it becomes quite useful when combined with what we know about stocks, as per our review above.

We can take advantage of similar diversification and valuation opportunities by also considering commodities, REITs, currencies and cash as additional components for our portfolio. In fact, we may even find additional risk management value by breaking equities into several constituent parts, i.e., by region, industry or style. Ditto for the other asset classes.

So far, we've only been speaking of risk management in terms of betas, which is to say index funds. But perhaps we can further broaden our opportunities by considering alphas, such as market neutral funds, merger arb funds, managed futures funds, skilled stock pickers, etc.

In addition, if we consider all of our potential choices in the context of asset allocation--choosing portfolio weights for each by way of some economic logic--we may be able to add another layer of risk-management value to our strategic aims. And once the asset allocation is set, the prospect of a "rebalancing bonus" avails itself. Rebalancing in this sense is applying a tactical overlay to the strategic asset allocation in the management of the various asset class components through time. This is yet another risk management tool that can aid our strategic cause.

There are additional risk management applications to consider, but we'll leave it here for the moment. The basic point is that by focusing on risk management, strategic-minded investors can improve their investment results compared to buying and holding the global market portfolio.

Of course, a few caveats are in order. First, there are still no guarantees. It's possible, perhaps even likely that an intelligent investor can wield all of the above and still fall short of the long-run returns available from buying and holding the global market portfolio, which is available to everyone at a very low cost and that requires virtually no adjusting. Why? One reason is that as we blend risk management strategies, we build a more complicated portfolio, and so we must monitor and manage more variables. At some point, we face the hazard of taking on too much. It's tough to make five flawless investment decisions year in and year out; it's even tougher if there are ten annual choices, or 20 or 30. Also, more complicated portfolios incur more transaction costs, taxes, and other real-world frictions that work to our disadvantage. The more active our portfolio, the higher our results must be to overcome the drag. Expenses, in other words, add up and take a hefty toll over time.

Having said all this, let's return to our main point, which is that managing risk is the only game in town. Predicting returns directly, and in isolation of risk management, is a game for fools. Even so, we must proceed down the path of managing risk cautiously, prudently and only after we've done our homework. Each investor must decide how many risk management techniques to embrace. Some--such as diversification--are so basic and fundamental to our interests that we can't ignore them. But to the extent that we are considering adding new layers of risk management to our investment strategy, we should do so judiciously.

Risk, it seems, is our friend and foe. With a little common sense, and an understanding of history, we can keep it in the latter camp. But that requires eternal vigilance. Success in risk management can unravel when our backs are turned. Perhaps that's one more reason to consider Mr. Market's global portfolio, which comes fully enabled with a self-sustaining risk management package, and at an attractive price.

Nonetheless, it's tempting to say that Tuesday's intraday low of 1200.44 for the S&P 500 certainly looks like the trough--for the moment. Yesterday's bounce skyward already has some pundits speculating that a return of the good ole' days is imminent. And, of course, there's a few select bits of news to support that notion, including a sharp drop in oil prices, a confidence-boosting announcement for the battered financials by way of a dividend hike for Wells Fargo, and some better-than-expected news on business conditions for three stalwart names in the Dow Jones Industrials.

Of course, we could easily counter the upbeat reports with bearish ones. In fact, that's always true. There's never a shortage of reasons to worry, or to hope. Depending on your mood, you can find corroborating evidence to support the forecast preference du jour.

Alas, there's virtually no chance of calling bottoms or identifying tops, at least not in advance, or ex ante, as the academics say. The rear-view mirror, on the other hand, is always reliably lucid. No wonder, then, that looking backward tends to have an oversized influence on investor sentiment today. The problem is that the past, sans an informed and thoughtful historical perspective, is of little help to the strategic-minded investor.

Indeed, developing strategic perspective is an unnatural act for the human species. That's not to say that it can't be learned. But the path of least resistance is one of extrapolating from the very recent past as a basis for anticipating the very near future. That may work for traders and sail boat enthusiasts checking the weather at sea, but it's bound to lead you astray eventually when it comes to finance.

Volumes have been written on how investors are at risk of becoming their own worst enemy when it comes to strategic thinking on matters of investing. We won't belabor the point here, other than to remind that the intersection of human psychology and money is a broad and rich field of study that's dispatched a sea of insights into how Mother Nature has left us high and dry for thinking prudently on matters financial. (For any one who's curious about behavioral finance, here's a solid overview of the literature.)

Reprogramming our heads for winning the investment game isn't easy, nor is it clear that there's a solution per se. More than 50 years of research in financial economics has taught us much about what works, and doesn't work in money management. But there are still no guarantees, and much of what we've learned has application only for long-term investing horizons. In many ways, we're as clueless about the short run as we've ever been, although that doesn't stop many from asserting otherwise.

As for the basic strategic lessons, it all boils down to:

1) Diversify broadly, across as many asset classes as you can reasonably and efficiently own; if you're not sure about how to weight and choose assets, Mr. Market's asset allocation will probably fare modestly well over time.

2) Minimize trading, reserving it for those times when your confidence about the future is relatively high. If you don't have much confidence about weighing the odds for what will happen down the road, then rebalance your portfolio every year or so, or perhaps more frequently when markets move dramatically. This advice, of course, requires a solid asset allocation benchmark as a basis for rebalancing. Not sure how to proceed? See item 1 above.

3) Keep expenses low, which is to say favor index funds as a general rule unless you have a deep conviction otherwise. But for most investors, passive investing will do quite nicely, even though it won't win the horse race.

4) Stay focused on the long run. Alternatively, if you don't have a long-run horizon, act accordingly with risk allocations.

If you're inclined to be active in your portfolio decisions, start by looking to take advantage of extreme moments on an individual asset class basis. That requires patience, since extreme moments, by definition, don't come along every other Tuesday. That said, if stocks are selling at high valuations, pare your exposure; if they're selling at relatively low valuations, raise the equity weight in your portfolio. (For some recent perspective on equity valuation, see our post from last week.) The same concept also applies to the other asset clases. In sum, be opportunistic, but neither chase performance or fall into a perma-bear state when prices slump for an extended period. And when you do rebalance, look to roll out the changes over the course of a cycle so that you don't bet the farm on thinking we've identified the bottom, or top, in real time.

Recognize, too, that almost everything we've learned about strategic-minded investing is less about boosting return than it is about lowering risk without paring much, if any return.

Finally, try not to get caught up in the tick-by-tick mentality of trading. We humans are highly vulnerable to what's happening now, this minute, this second. And we like to judge our success, or failure, based on what happened in the previous week. It doesn't help that we like to mingle with other investors at cocktail parities and compare notes. No, we're not suggesting that we all become monks and cancel our news subscriptions and real-time data services. But strategic success will require some compromise and concession, and that includes giving up some of the entertainment that comes by watching markets in real time.

A little common sense, in other words, is also necessary for strategic success. Perhaps there's some hope of investment victory after all.

Before we dive into what may, or may not happen, let's review the latest numbers. Consumer prices surged by 1.1% last month, the Bureau of Labor Statistics reports. That's the highest monthly gain since 1981. On an annual basis, CPI rose by 4.9% through last month--the highest since 1991.

There's no doubt what's behind the price hikes: energy prices jumped 6.6% last month, the government reports. The surge in energy costs spilled over into transportation, which climbed 3.8% last month. Food isn't lying low either, although its 0.8% advance in June looks modest by comparison with energy and transportation.

The Fed, of course, likes to focus on core inflation, in part because a number of economic studies have shown that it's a better predictor of top-line inflation. That's certainly been true in the past, although there's a danger that the old relationships are breaking down, as we've discussed many times over the years, including here and here.

It doesn't take a Ph.D. to recognize that a slump in oil prices would go a long way toward salvaging the belief in core inflation as the better yardstick for setting monetary policy. As luck would have it, crude prices dropped sharply yesterday. The August '08 contract in New York shed more than 4% yesterday. Even so, we'll need a lot more down days to take the edge off inflation. Crude, after all, is still lurking at almost $140 a barrel as we write.

Still, the prospect of demand destruction for energy, along with a lot of other goods and services can't be dismissed at this point. The economies of both the U.S. and Europe look set for more weakness in the balance of this year and probably well into 2009. The underlying factors driving the weakness are by now familiar, including a liquidity crisis in the financial sector, a real estate correction, rising unemployment, and soaring commodity prices. All of which promises to nip demand in the bud in the coming months and quarters.

Recession, in short, is still very much a threat. In addition, the prospect of slow/no growth economy after the technical end of the recession remains a distinct possibility. As such, one can imagine that oil prices will correct, or at least stop rising once the market fully factors in the economic outlook. In turn, an oil price correction would go a long way toward keeping inflation in check from here on out.

But let's not get too giddy. Rising commodities prices generally, and oil in particular, are based on a fundamental shift in the supply/demand equation in the global economy. To restate the obvious: demand has risen sharply in recent years while supply growth has lagged. Perhaps we'll enjoy a break from the trend and see energy prices fall in the wake of economic slowdown or worse. Maybe. It all depends on how much of a global slowdown we're looking at, and how much influence the U.S. has over oil prices these days. The latter subject is open to debate, thanks to the rise of China, India, etc. and the relative maturing of the U.S. economic growth outlook compared with emerging markets.

In any case, it wouldn't surprise us to see oil prices drop sharply from current levels. Volatility and commodities, after all, are old friends, regardless of economic conditions. Longer term, however, it's unlikely that oil prices are due for a sustained fall. Noise may dominate the short term, but supply and demand dictate price trends over time. That means that while inflation pressures may ebb for a time, the respite will only be temporary, assuming it comes at all.

Today's update on wholesale inflation for June suggests that inflation may get worse before it gets better. The annual pace of producer prices was an astonishing 9.1% through last month--the highest since 1981. And there's no salvation in focusing on core wholesale prices, which rose by 3.1% for the year as of June--the highest since 1991.

No matter how you slice it, wholesale inflation has taken wing. We can only guess what tomorrow's report on consumer inflation will show, but it would come as no surprise to see higher numbers on that front as well.

Adding to the inflationary woes is the bubbling of prices in overseas markets, starting with China. That's doubly troubling because in China's reaction to fighting rising inflation is less than encouraging. As the Wall Street Journal today reports, "China Falters on Inflation Fight."

Some of the problems are related to the dollar, which continues to weaken. Indeed, the buck hit a new record low against the euro today. China long ago hitched its currency to the greenback, which means that U.S. monetary policy is exported to China. Breaking free of the relationship, which effectively gives China a looser monetary policy than its domestic economy warrants, is proving difficult, in part because to do so threatens to materially slow the Chinese economy. Having grown used to 10% economic growth, China's in no mood to tighten their belts, especially right before the high-profile summer Olympic games. But as the U.S. learned in the 1970s, printing money as a tool for boosting economic growth is, at best, a short-term fix, and one with a hefty price tag once the party's over.

Meantime, oil and many other commodities are priced globally in dollars. No wonder, then, that as the dollar falls, commodity prices rise. Or is it vice versa?

In any case, all eyes will be on Fed Chairman Ben Bernanke in his testimony to Congress today and tomorrow. It's not clear that he can say anything to wipe away the worries, although there's the possibility that he could make things worse if he's not careful with his chatter.

As such, strategic-minded investors should stand ready to start nibbling at asset classes, particularly if they spike down in the coming days and weeks. U.S. stocks, junk bonds and REITs have been particularly hard hit of late. Meanwhile, we're not inclined to chase commodities at these levels, although fully selling out previously established positions isn't recommended either. Nonetheless, if you've owned commodities for some time, it's a good time to start thinking about rebalancing from winners to losers on an asset class level. No, we're not sure that bottoms in stocks, junk and REITs are imminent, but if you have a long-term horizon you could do a lot worse by starting to buy, albeit cautiously and with an eye on time diversifying purchases over the coming months and perhaps even years.

More generally, a fully diversified global portfolio across all the major asset classes is still the only game in town. The good news is that some portions of the global asset allocation pie look more attractive on a long-term basis than others. That's always true, but it's been quite a while since the differences have been so stark. In short, this is no time to be blinded by the volatility. Opportunities like this don't come along every day. Even so, no one said this is going to be easy. Tapping risk premia takes a lot more discipline than it used to. Inflation, it seems, really is everywhere in 2008.

No wonder, then, that we've become a broken record on the subject. Our only defense is that our recurring message is a reflection of the consistent rise in import prices, which we've written about regularly in the recent past, including here and here and here.

12-month rolling change in U.S. import prices

Source: Bureau of Labor Statistics

The rationale for doing nothing is that a recession/deflation risk coexists with the inflation danger, as the Bank for International Settlements noted in its recently published annual report:

This combination of rising inflation pressures and financial disturbances
slowing demand growth is open to a spectrum of interpretations. On the one
hand, if slower growth were thought just sufficient to hold global inflation in
check, albeit with a lag, this could be viewed positively. On the other hand, the
eventual global slowdown could prove to be much greater and longer-lasting
than would be required to keep inflation under control. Over time, this could
potentially even lead to deflation, which would evidently be less welcome.
Unfortunately, when one considers the possible interactions between a
weakening real economy, high household debt levels and a severely
stressed financial system, such an outcome, even if unlikely, cannot be ruled
out entirely.

With conflicting signals swirling about, these are not easy times for central banks. Dealing with one or the other is within policy powers of the Fed (assuming the discipline to carry out the relevant monetary prescription). Tackling both simultaneously, however, is more of gray area, with limited precedent of success for encouraging optimism with the current battle.

That leaves us to question whether it's time to hedge one's bets a bit by at least tightening slightly. For the moment, the Fed is having none of that and instead seems intent on betting exclusively on the recession/deflation risk, in effect hoping that the inflation hazard will fade away in due course.

It's a nice theory, and it may ultimately prove accurate. But heaven help the man in the street if the Fed's wrong. So far, one can argue that the bet has been a net loser for Joe Sixpack, courtesy of the bull market in oil. Crude's priced in dollars and to the extent that dollar-based inflation is a problem, oil prices will rise in sympathy. True, supply/demand factors are also pushing up oil prices, but a portion of that rise is surely linked to the weak dollar. And with the Fed's current monetary stance, combined with Europe's monetary tightening, the dollar may weaken further.

It's anyone's guess if Bernanke & Co. will win this game of chicken. So far, there's not yet much sign of success in the numbers, least of all in import prices. Even if you take out petroleum, which is the primary source of the imported inflation, import prices are still climbing by more than 7% a year. That's better than 20%, but it's still not encouraging, all the more so when you consider that higher oil imports are this country's destiny for some time to come.

By comparison, the 10-year Treasury yield is a mere 3.81%, as of last night's close, and Fed funds remain at 2%.

For the moment, we're left to wonder (and hope) that next week's update on consumer prices will bring better news on the inflation front. Meantime, it promises to be a long weekend.

It's a fundamental relationship, and one that endures. No wonder, then, that a growing body of academic research (and a healthy dose of common sense) counsels that the relationship produces valuable clues for strategic-minded investors. In short, raise equity weights when yields are relatively high, and trim that exposure when yields are relatively low. Ideally, such shifts are done gradually, over time, to manage the risk that no one really knows if current yields will remain the apex, or trough, for the cycle.

There are other factors to consider in managing portfolios of course. For the moment, however, we'll focus on dividend yields, which are up these days, as our chart below shows. Indeed, some corners of the world's equities markets are sporting rather attractive yields, relative to recent history.

Europe leads the way among the globe's major regions, posting a 4.35% yield (based on the trailing 12 months) as of June 30, 2008. (All data is via S&P/Citigroup Global Equity Indices.) How high is 4.35%? It's the highest in at least 13 years. After factoring in the selling so far this month, the current trailing yield is almost certainly a bit higher today.

Meanwhile, developed markets in Asia are at a new post-1995 yield high, as is the developed-world equity market ex-U.S.

It's a different story in emerging market stocks. As our second chart below reveals, yields are still middling relative to the their history since 1995, ranging from 1.38% for Latin America up to 2.65% emerging Asian markets, as of June 30. Of course, one might argue that the allure of the emerging world is the growth potential rather than its yield capabilities, and so dividends aren't all that important here. Perhaps, although for the moment there's not much growth in share prices anywhere and so dividends are a lone bright spot.

In the long run, dividends do matter, at least for a broadly diversified portfolio. No one should buy, or sell stocks solely because of dividends, of course, or any other single metric. But neither should strategic-minded investors ignore the income stream produced by stocks. Indeed, when equity yields move to extremes, the associated signals about prospective returns are more reliable. History, at least, tells us so.

The eternal question, of course, is whether we can accurately identify extreme levels in real time. Inevitably, that's a speculative task and prone to error. Nonetheless, it's clear that in some markets we're quite a bit closer to the extreme than we have been in quite a while. As a result, the odds have improved for buying now in anticipation of receiving relatively higher total returns over the next five years-plus compared with buying six months ago.

That doesn't mean that yields won't be even higher down the road, or that buying today insures a profit as of, say, July 10, 2013. The future is always unclear, and that introduces risk. But at least we have some clues about what's coming, a message that boils down to the basic lesson that Ben Graham taught us all those years ago: valuation matters.