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Quarterly Newsletter April 2005

Quarterly Newsletter | April 2005         Radical Thoughts on Asset Allocation

Every so often it can be enlightening to read some contrarian thinking --- particularly about an investment strategy that has so thoroughly pervaded the industry. Fixed, long term (strategic) asset allocation has been standard operating procedure for investment managers for many years. Based on the work of economist Harry Markowitz, it formed the basis of modern portfolio theory. In a nutshell, advisors no longer had to worry about which stocks, bonds or mutual funds were chosen. Simply allocate assets to stocks, bonds and cash based on the investor’s risk tolerance and time horizon and the job is virtually done. Periodically rebalance the portfolio to restore original allocations. This led to the boom in index funds. Then theory collided with reality. Rather than spreading money all over the map, clients thought asset allocation should mean concentrating their portfolio in the asset classes that were doing the best and avoiding the asset classes that were in a bear market. So, while everyone embraced asset allocation, advisors and clients had a different take on it. Maybe the clients were right!

Is it time to abandon the notion of fixed strategic asset allocation? Some experts think so. The problem is that the studies that supported asset allocation were flawed. And to compound things, the interpretations of those studies were also wrong. Investment opportunities change over time. So asset allocation should be viewed as a dynamic process. Only if expected returns are fixed should asset allocation weights be fixed.

Belmont Financial uses tactical or a flexible asset allocation strategy. Based on a study of economic trends and a detailed review of the risk and return of over 50 world-wide asset classes, BF allocates assets only to the most attractive asset classes. For example, for many years we’ve had no exposure to US large cap growth.  This made sense given the run up in the late 90s. Also, given the fact the Fed is raising interest rates, we have avoided Treasuries and other interest rate sensitive sectors. We sold our positions in REITs and High Yield bonds. It requires more work, but adds value by keeping portfolios invested in top performing areas of the market. This makes BF unique. Many, and perhaps most, advisors employ a fixed, strategic asset allocation. This benefits the advisor – less work, but hurts performance.

Market Comments

The first quarter saw mostly red ink in the financial markets. Somewhat unusual was that both stocks and bonds experienced losses. The S&P 500 was down 2.5% the first three months, while investment-grade bonds, as measured by Vanguard Total Bond Market Index Fund, dropped 0.5%. Also unusual, mid-caps outperformed both larger- and smaller-cap stocks. Among other asset classes, foreign bonds (the Salomon World Government Bond Index) dropped 2.6% in the first quarter, due to the dollar retracing some of its losses. Our mutual funds, invested in top performing asset classes, continue to excel.

In the past year, there has been no shortage of uncertainty. Concerns about sharply rising oil prices and overall inflation, rising interest rates, and risk to the dollar from our massive current-account deficit have all weighed on the markets. While markets have reacted, and sometimes overreacted, to short-term news, I have not seen any misvaluations reach the threshold for taking a tactical position. Still, ongoing volatility makes me confident that it is only a matter of time before the inevitable forces of fear and greed create valuation excesses in one direction or another, creating opportunities to add value. We can never know when or how the next opportunity will show up. Often it results from a surprise event, which by definition is impossible to predict, and sometimes it’s just a slow grind: an asset class moves in one direction for an extended period of time, and finally gets to the point where it is either cheap or expensive. While there are no great tactical return opportunities now, I am focusing my efforts, as always, on carefully monitoring over 50 world wide asset classes for risk and return. This will enable us to quickly identify and act on the next good opportunity. We are also continuing our ongoing efforts to identify exceptional fund managers who can add value even if the markets don’t give them a lot to work with.

Asset-Class Update

Foreign Bonds: Absolute yields on foreign bonds as a whole are now lower than in the U.S.However, real yields are lower in the U.S. than overseas, which implies that their bonds might still be a better bargain on a valuation basis.

Given the huge decline in the dollar over the last few years (30% in trade-weighted terms), one would normally expect our trade balance to improve at least somewhat. However, our current account deficit as a percentage of GDP has continued to worsen, and the most recent reading came in at a staggering 6.3%, an all-time high. It is possible that the currency has declined enough that things will start to improve, but the extent of the current account deficit could demand further declines.

There is a geographic issue to contend with as well, since some data suggests that the dollar may have run its course against the euro, but hasn’t necessarily done so against several other currencies, particularly in Asia. Japan, for example, is a highly export-dependent country. And because their economy has been virtually on the edge of deflation for years, they have made a concerted effort to depress the yen (thereby making their exports less expensive to foreign buyers) by buying huge amounts of dollars. China is also an issue. They represent perhaps the largest source of our trade deficit, but because the Chinese authorities have pegged the value of their currency to the dollar, our currency has not been able to depreciate to correct this imbalance. China has indicated that they are not going to change the peg in 2005, but they have made some comments that they may loosen up the band in the future.

I don’t think a dollar crash is likely. The central banks of the world understand that a sudden, severe decline in the dollar would be terribly destabilizing to financial markets around the world, and so it is likely that they would present a unified defense of the currency in the event of a crisis. And the continued ballooning of our current-account deficit suggests that further declines in the dollar are still likely, and therefore foreign bonds may continue to outperform domestic investment-grade bonds, while still providing insurance against a dollar crash.

Equities (U.S. and Foreign): In a base-case scenario, I expect both U.S and foreign equities to return high single digits on average over the next five years (returns could vary widely in individual years). On the positive side, though earnings are slowing they are still likely to be in the mid single digits. And while interest rates are moving higher it is quite possible that they will remain low enough to be fairly accommodative. Valuation models assume that rates are about 50 basis points (0.5%) higher than the current level and at that point the S&P 500 is still comfortably in a fair-value range. Other positives include relatively cash-rich corporate balance sheets and a pick up in capital spending.

But it is also important to recognize that the fundamentals that go into the valuation model can change, which would alter return expectations. Some of the risks out there that could impact fundamentals include:

  • Higher oil prices, changes in accounting rules, increased pricing pressure from overseas competitors, rising health-care costs, etc., leading to lower-than-expected profit margins and earnings growth.
  • Macro level risks—a dollar crash, a debt crisis, unexpected inflation, a large-scale terrorist attack, etc.—could result not only in big short-term moves in the equity markets, but could also materially impact the average return we see over a multi-year horizon. Longer term there is also the risk that interest rates will move to levels that are high enough to negatively impact multiples. If this happens then five-year returns could be somewhat lower than the base-case forecast.

I suspect the market isn’t fully discounting some of these bigger risks. At this moment in time, I think the overall level of risk is probably a little bit higher than average, so I think it’s prudent to manage our expectations a little lower than what the numbers are telling us.

Investment-Grade Bonds: Inflation has been on the rise, and it isn’t just oil prices. Core inflation, which excludes the volatile food and energy sectors, has risen from a low of just over 1% in late 2003, to 2.4% as of February. This number is still reasonable by historical standards, but the rate of change has been more severe than what we’ve seen in many years. My guess is that this number will continue to increase, and the Fed will continue raising interest rates, albeit at a measured rate. This backdrop is not terribly favorable for bonds, especially given the very low level of real yields. On the positive side, bond yields have indeed been climbing recently, and higher yields contribute to better nominal returns. This has been less noticeable at the long end of the yield curve, but intermediate-term bond yields have increased by roughly 50 basis points in just the last few months, and some taxable money-market accounts are yielding upwards of 2%. Given the Fed’s current trend, those cash yields are likely to increase.

I continue to see taxable investment-grade bonds as being overvalued (return expectations are in the 4% range over the next several years) and I have underweighted this asset class in portfolios. But given the risks out there that could lead to large or sudden drops in equity prices, bonds can still play an important role in volatility control for certain portfolios.

In Closing

Given the recent lack of compelling opportunities, we continue to look to our active managers and tactical asset allocation as a source of added value. We can’t be certain this will be the case over shorter time periods; over longer time periods I am confident this will be the case. On the asset-allocation side, our current tactical allocations are geared towards foreign securities and small- and mid-caps and multi-sector bond funds. While there are no return-based fat-pitch opportunities, we continue to monitor asset classes closely, and stick to our discipline of waiting for only those opportunities that are highly compelling. By doing so, we believe that over the long term we increase the odds that the tactical moves we make will add value and help us outperform our benchmarks.

Please contact me if you have any questions or comments or if you would like to review your portfolio. Thank you for your continued trust and confidence. I look forward to seeing you soon at our periodic review meetings.

Mike Durant, CFP® April 2005,   617-489-0040