MICHAEL CEMBALEST'S JOB IS TO MAKE sense out of the chaos of the markets and global economy -- and then to find suitable investments for the ultrawealthy clients whose portfolios he manages as chief investment officer at JPMorgan Private Bank in New York. His job also entails asset allocation and portfolio construction, responsibilities that take him far beyond trawling for plain-vanilla stocks and bonds.

Cembalest, 47, has been with the firm since 1987; currently, his investment outlook is cautious, given the huge fiscal and monetary stimuli washing through the financial system. "I go back and forth as to which is the scarier nightmare -- the withdrawal of the monetary stimulus or the withdrawal of the fiscal stimulus," he says.

So he's been raising cash, allowing him to move quickly as new opportunities arise, and dialed down the equity allocation. Some of the investments he likes heading into 2010 include nonperforming loans and private-equity stakes that financially stressed institutions are unloading. Barron's caught up with Cembalest earlier this month at the private bank's headquarters in midtown Manhattan.

Barron's: How did the recent financial collapse change the investment world?

Cembalest: There was a presumption that, somehow, securitization was a benign, if not healthy, process of diversifying the risks in the markets amongst lots of different holders. But not enough attention was paid to the deterioration in underwriting standards that was taking place.

I worked at JPMorgan in the 80s, at the inception of the credit-derivatives markets. A handful of banks in Detroit were more or less required to dedicate massive amounts of their balance sheets to lending to the auto companies, and the earliest stages of credit derivatives actually helped them reduce their massive auto concentration. That was a healthy thing.

But by 2004, you started to get some pretty egregious deterioration in the quality of underwriting standards. By 2006, we had purged our own portfolios of all structured credit. Whether it was subprime loans, credit cards, commercial real estate, consumer loans or corporate loans, the underwriting standards deteriorated sharply, and there are some legitimate questions to ask, including the role of the rating agencies. But there is no question that some of this was set in motion by a roughly 1% fed-funds rate back in 2002.

Did the financial crash change things in terms of portfolio construction and asset allocation?

There was a massive underappreciation of the benefits of having liquidity. And the private-equity industry gets some well-deserved criticism for having invested money, at times, three to four times faster in that 2006 vintage year than it had in the past. But the overwhelming mistake that many investors made was not actually having an allocation to private-equity deals in 2006; it's that they increased their allocation so much.

For people that had adhered to disciplined portfolio construction and constant exposure by laddering their private-equity holdings [with different vintages], you have not had the same kinds of adverse consequences as you have had with some of the university endowments, foundations and pension funds that made radical changes to their portfolio construction as the markets were getting more expensive. In 2006, we wrote a note to clients saying, 'You are not the Yale Endowment' -- because we were so concerned that people were shifting their allocations at the wrong time.

Also, over time, more and more assets have become highly correlated. In the 70s and the 80s, you got meaningful diversification benefits by holding Japanese equities versus European equities or versus U.S. equities. By and large, once you strip out the currency issue, a lot of those diversification benefits are gone. That means you are going to have a lot more directional risk in global portfolios, irrespective of your regional diversification decisions.

So how do you go about getting proper diversification?

It's not so simple. Some people say to just throw in things like commodities. But those are extremely tactical investments, where the timing of when you buy and when you sell matters a lot. So, overlaying traditional portfolios with timing decisions on things like commodities is part of the solution. Another part of the solution -- and this is easier said than done -- is trying to invest in things that are less sensitive to the profit cycle. For example, most of our hedge-fund book is long-short managers that have a very low net exposure to the market. They will succeed or fail based on their ability to pick stocks.

What's the proper role of alternative investments?

For me, alternative investments are about three things. First, there are vast majorities of business opportunities in venture capital, private companies and real estate that are not publicly traded. So having an allocation to alternatives broadens your ability to invest in parts of the economy that you otherwise would not be able to.

No. 2, wealthy people are often, though not always, in a position where they can trade off some liquidity in exchange for additional return. People overdid it in the prior cycle. There is a lot of second guessing there, and I feel pretty good about how we resisted the wave.

If you asked anybody on the Street five to seven years ago who was the most famous investor in the country, they would have said Warren Buffett. If you asked that question three years ago, the answer would have been David Swensen of the Yale Endowment. It was a sign of how people were moving way too far, too fast towards illiquid assets [such as private equity], although some degree of sacrificing liquidity in exchange for return makes sense. The third issue is the ability to isolate stock selection from overall market exposure, as is the case with good long-short managers.

What's the outlook for private equity?

The industry data available to make assessments about the lifetime experience in private equity are not as clean and clear cut as people would like. And people draw different inferences by looking at the data in different ways.

I haven't seen an incontrovertible statement that private-equity allocations outperform public equities over long cycles by predictable amounts on an industrywide basis. If you work with good managers over the long term, don't try to market-time your private-equity allocation, and don't radically change your allocation -- which for us is 5% to 7% of a balanced portfolio; it is not going to be either the savior or the death knell for any portfolio.

Those kinds of allocations can make sense over time, but you have got to work with the best managers to get the best results. Looking back at the 2006 cycle, the goal posts have changed. For that cycle, the goal posts are now returning client capital. If they can return clients' capital over seven or eight years -- after having bought at peak valuations and having over-leveraged -- they would see that as peace with honor.

Right now, though, it's almost like a flashback, because we are starting to see private-equity deals at the multiples that I saw when I came into this business in the mid-1980s -- at five to seven times free cash flow.

What kinds of hedge funds are you investing in?

We are pretty heavily focused on funds whose returns are ultimately a function of their security selection and not just their market exposure. So we are invested in a lot of low-net-exposure long-short funds. We also do some things with commodities and credit. The credit side is interesting, because we made some very aggressive allocations there earlier this year. I thought we'd have a nine-month window to take advantage of those opportunities, but it turned out to be a three-month window.

For investments like high-yield bonds?

Yes, we are seeing some fantastic returns in 2009. When we saw this wall of federal stimulus coming, along with the monetary stimulus, our first reaction was to say, 'OK, let's take an aggressive run on credit opportunities.' We bought municipals, high yield, and billions of investment-grade corporate bonds in client accounts, particularly in those that don't pay U.S. taxes. We also bought leveraged loans and convertible securities. And we bought commercial mortgage-backed securities and residential mortgage-backed securities.

What is your outlook for 2010?

There are several leading indicators that would normally have you be very optimistic. They include purchasing managers' surveys on employment, purchasing managers' surveys on manufacturing, positive earnings revisions, and a tremendous amount of pent-up cash on corporate balance sheets. And inventory reduction has been just so severe that even a slowing of inventory reduction would contribute a lot to growth. Very large sovereign-wealth funds, in China and throughout the rest of Asia, have announced intentions to radically ramp up the pace of acquisitions they are making offshore. Normally, with this gaggle of positive leading indicators, we would be very aggressive about risk-taking, because we have seen what has happened when these indicators start to turn positive.

What's holding you back?

The fiscal and monetary experiment taking place right now is the largest one since the Reformation -- and I don't think that's hyperbole. So it's very hard to strip out from all of these signs of economic improvement how much is truly organic and how much is a function of what has been a globally coordinated effort. Woodrow Wilson would be so happy right now, because this is his vision of the League of Nations, writ large. Just about every country in the world has agreed to provide tremendous amounts of monetary stimulus, fiscal stimulus, and bank-deposit guarantees. It's the most coordinated international financial effort ever. But it is very difficult to extract how much of some of the incipient good news is happening organically and how much is happening from stimulus.

How have you set up the portfolios that you manage?

We are positioned for some additional increases in asset prices, but we are expecting 2010 to be at times a difficult year. The steroid injections have all taken place, and the benefits of stimulus are washing through the system in so many different ways. For the most part, none of their costs are being felt yet. And so we will start to feel some of these costs, probably in 2010.

It sounds like you're quite cautious.

We probably own 10% to 15% less in public equities than we would if that stimulus backdrop were not there. I wouldn't rule out an immaculate-conception recovery by the private sector, where it essentially takes the handoff from the public sector and runs with it. But to position our portfolios for that kind of immaculate handoff lies beyond our risk tolerance.

Where, then, do you see investment opportunities?

For equities, I use that phrase carefully: Our allocation is underweight relative to where we would normally be. Right now, some people think this is the equivalent of November 1982, the fall of 1975 or other periods at the inception of a very long period of stable, positive equity markets. We are underweight relative to that view.

But our equity weightings in the balanced portfolios, which take on a moderate level of risk, are somewhere between 35% and 40%. Unfortunately, some of the easiest returns were made this year. This is not new. If you go back and you look at almost every prior crisis, either in equities or credit, the recoveries come so far before the improvement in fundamentals.

For example, some find it shocking that bank stocks have rallied substantially, and we are not even halfway through the bank-default cycle. The same thing happened in the early 1990s, and the same thing happened during the Depression.

What's the challenge for investors?

The recovery in financial-asset prices takes place so early in the process, relative to fundamentals, that by the time we are in the first quarter of 2010 and people can see some of those visible improvements, they've long since been priced into financial assets. We began shorting the dollar a year ago, and now it is down considerably. So now is not a great time to have the epiphany that the U.S. is debasing its currency. The time to have done that was a year ago, when we saw the inception of that policy.

We bought oil in January of this year at $38 a barrel, versus around $76 last week. So the time to have had those epiphanies was a while back, whether you're talking about shorting the dollar or buying oil or buying credit. A lot of these assets have moved substantially, which is one of the reasons we expect our portfolio construction to be pretty conservative in 2010. The easier gains were had in 2009.

What assets look interesting?

The flood of liquidity has caused a lot of easily accessible financial assets to rally. But the residue of the worst recession and business climate in 70 years is still there. There are still pockets of what we call other people's mistakes.

Back in the spring, as we saw the credit crunch taking place with respect to some of the Ivy League endowments, we raised a fund to do secondary private-equity investing. One of the opportunities we are looking at for 2010 is nonperforming loans. In every banking crisis, there is a point at which the banks just want to sell those loans. We are doing that both in Europe and in the U.S.

In the U.S., there are upward of 8,000 banks. And when they fail, the nonperforming loans are either sold with or without the deposit base. One of our efforts is to purchase nonperforming loans as part of the FDIC [Federal Deposit Insurance Corporation] process. So far, about 120 banks have failed. There are another 400 or 500 on the watch list. I don't know how many of those will ultimately fail, but I guess at least half.

In Europe, there are far fewer banks, because there has been more consolidation, so banks don't fail as much. When you buy nonperforming loans in Europe, you are dealing with a going concern, and it's a different process. This is the kind of investment opportunity that is almost impossible to execute in any kind of publicly tradable vehicle, but it does make sense for alternative managers.

Any other interesting opportunities?

One of the reasons we own fewer equities than we normally would is that we want to hold some liquidity in reserve for the opportunities that may emerge.

Closing thoughts?

The latest investment we made was in a portfolio of equities that automatically converts to cash if the market goes up another 7% or 8%. So we are looking to benefit from this reflation experiment -- but want to do so in a very disciplined and cautious way, because we also want to maintain our ammunition for what lies ahead.

Another important point is that the corporate sector itself -- which, outside of the banks, has done a phenomenal job managing what we refer to as operating leverage.

In 2001, for every dollar of revenue decline, companies cut about 88 cents. That's tough to do, and that's good work in terms of maintaining your operating margins.

This time around, the revenue decline was three times larger and the corporate sector still cut about 88 to 90 cents on the dollar. That's hard to do. But they have now retained that operating leverage. With some degree of recovery, the chances are that profits are going to exceed peoples' expectations. So corporate profits have a lot of operating leverage built in.

Thanks, Michael.