NYTimes (1/25/13): “Americans seem to be falling in love with stocks again.”

fee-only financial planning2012 was a great year for stocks. Already, in 2013, the main indices are up 5%. Investors are piling into equities, apparently afraid of missing out. Have we reached the “tipping point”, when allocations to bonds should be reduced and equity allocations increased?

 

 

 

Certainly, there has been some very good news recently:

  •  Washington avoided the “fiscal cliff”
  •  European leaders seemed intent on saving the euro
  •  The U.S. debt ceiling has been raised for three more months
  •  The Fed and other central banks have pledged to continue monetary easing
  • China’s GDP growth is up in the fourth quarter to a 7.9% rate from 7.4%
  • The housing market recovery seems to be continuing
  • New claims for unemployment benefits fell to the lowest level in five years.

All good news. But, let’s put it in perspective. Yes, the current financial crises seem to be under control. Yet, the global economy is not back on track yet. Ken Rogoff, Harvard economics professor, put it this way at World Economic Forum in Davos, Switzerland last week:  “It is a little bit calmer, but it is not very pleasant.”

Here in the U.S., our economy is healing, but slowly. The initial forecasts for 2013 were 2% growth in GDP. Now, with the rise of payroll taxes on employees, the new forecasts are for 1% growth. At the same time, the IMF expects the euro-zone economy to shrink by .2% this year. Unemployment in Europe is 12%. With continued austerity programs and tight credit, Europe may not return to growth for some time.

At Davos, a key buzz word was “structural reform.” Europe still is plagued by its lack of competitiveness. And, here in the U.S., the fiscal cliff was avoided by basically “kicking the can down the road.” We have simply averted major crises. The major problems in developed countries hindering global long-term economic growth haven’t been solved and haven’t gone away.

Yes, there are more positive signs today than 18 months ago, including the level of the major stock indices. However, as Brett pointed out in his last market commentary, stock market returns are not directly correlated with the global economy. The S&P 500 index may show good returns in shaky or even slow times. With the unsolved global economy headwinds, we are cautiously optimistic.

Hence, it’s a great time to review your asset allocation. An excellent time to review your risk tolerance, risk capacity and risk perception. And a perfect time to meet again with you DWM financial advisor.

Focus on Asset Allocation-Not Uncertainties

fee-only financial plannersAre you nervous about the fiscal cliff (or speed hump)? How about the U.S.budget and debt? Europe? Sure, all of these uncertainties are concerns. But none of us can control those outcomes. What we can control is our asset allocation. That’s where we need to focus.

 Ask yourself these two questions:

1) How will your portfolio withstand the next bear market?

2) Will the returns in your portfolio likely outpace inflation?

Let’s start by reviewing what happened in the last two bear markets; the financial crisis starting in September of 2008 and the Europe/US Debt ceiling and downgrade concerns of 2011. For simplicity, we will use the S&P500 index plus dividends as a proxy for equity returns, the aggregate bond index (“AGG”) as a proxy for the fixed income returns and a basket of liquid alternative securities* as a proxy for liquid alternatives (“liquid alts”).

 

  Last Bear Markets:

Asset Classes

Equity

Fixed

Liquid Alts*

9/1/08-3/31/09

               -37%

3%

-4%

4/29/11-9/29/11

-14%

5%

-3%

5yr annual return through 9/30/12

1%

6%

7%

                                    

What this demonstrates is that in bear markets, fixed and liquid alternatives perform much differently than stocks. AGG, which is comprised of 40% treasuries and 30% agencies, actually performed inversely to equities. That is, when everyone is concerned about stocks, there is a rush to safety. U.S.treasuries may not be what they always were, but they continue to be the safest port in the storm. Liquid alternatives, as DWM clients know, are designed to participate in up markets and protect in down markets. Hence, they are uncorrelated to the stock market.

Let’s average the two most recent bear markets and see how three hypothetical portfolios did. Portfolio #1- 80% equity/ 20% fixed, Portfolio #2- 50% equities/ 50% fixed, and Portfolio #3- 25% equities/ 50% fixed/ 25% liquid alternatives. You can do the math. Portfolio 1 would have been down about 19%, portfolio two down 10%, and portfolio 3 down about 4-5%. If you can’t withstand a 4-5% hit to your portfolio, you should highly consider reducing the equity exposure to 15% or even less.

Of course, we haven’t discussed diversification of the portfolios within the three asset classes. Our typical DWM client has their equity exposure currently allocated to ten different equity subclasses, their fixed income exposure to eight fixed subclasses and their liquid alternative exposure to ten different yet complementary strategies.

Now the second question:  If you are sitting in 50% to 80% equities, you could be looking at a loss on your portfolio during a bear market of perhaps 10-20%. If the next five years are similar to the last five years, your upside potential is small. Furthermore, if you have a portfolio of 50% equity and 50% cash, you may have the worst of all worlds: A portfolio that likely will be down 10-15% in the next bear market with only a small upside. Sure, if you are nervous about the future, you can keep all of your money in cash. But, that is a losing long-term strategy, since inflation will continue to erode your purchasing power.

No one can predict the future. We believe your portfolio should be allocated based upon your risk tolerance and goals and should be designed to help you protect your assets and grow them. We suggest you not focus on the many uncertainties that exist, but rather focus on getting your portfolio in a position to withstand the next bear market while at the same time providing expected returns in excess of inflation. I’m pleased to say our DWM clients have already done that.

‘*The basket of liquid alternatives used for this writing was an equal weighting of the following public securities that are generally considered to be in the “liquid alternative” strategy:  ARBFX, MFLDX, RNDLX, AMJ, PAUDX, FLARX, SCNAX, RWO, GLD, GCC.  This basket may or may not match DWM’s specific Liquid Alternatives Model and is for discussion purposes only. One cannot directly invest into an index. Past performance is no guarantee of future performance.