Using Asset Allocation to make money in a Flat Market

Top 10. Aug 1, 2002 10:22 AM

» DennisL - Re: Couch Potato Results : YTD Thru 7/31

In response to message posted by Rande:

Thanks, Rande.

You said, On the flip side, when the market eventually turns up again such an approach requires the courage to underperform relative to being concentrated in and/or over-allocated to the "hot spots."

Your remark reminds me so much of the high-tech and aggressive growth fund go-go days of the mid and late 1990s. Around the water cooler here at work, at cocktail parties, or wherever I went and espoused the virtues of the couch potato portfolio, I was ridiculed and laughed out of the room by everyone else. They were all loaded up on high-tech stocks and aggressive growth funds, and bragging about how they were raking in 40%, 50%, 60% a year, or more.

When I talk to these same people now, the honest ones lament the fact that they have now lost 70% or 80% of everything. Even more shocking is that many of these people still refuse to diversify. They say things like, "Tech is still best. It will come back." and "Oh, well. I'm in it for the long run."

Thanks in very large part to your invaluable contributions to this site, I guess I got the last laugh. <img src=/images/emoteicons/happy.gif alt=smile>

-- posted by DennisL

The Last Shall Be First

Top 11. Sep 3, 2002 2:00 PM

» Jen_ - Re: Dynamic Asset Allocation Works!

In response to message posted by DennisL:

This from 9/2 Barron's...

Why asset allocation makes sense now -- and always has

By JACQUELINE DOHERTY

During the go-go years of the late 1990s, diversification was a dirty word. And why not? Large-cap growth stocks led the market for four years running, and anyone sensible enough to have allocated assets to fixed-income investments and international stocks paid a large price for doing so. But that was then, and this is now. And after a crushing two-year decline in U.S. equities, diversification doesn't seem such an outdated notion after all.

Not everyone was surprised by the rotation in the markets, however. Diana Joseph, a senior portfolio manager at Mesirow Asset Management in Chicago, has been giving out a chart (EC: see chart below) to her clients for years. It illustrates how the seven major asset classes have performed during the past 21 years, and brings home the point that the market geniuses of the late '90s often were just in the right place at the right time.

"It gives people perspective," says Joseph. "The last shall be first and the first shall be last." Indeed, each segment has had its turn as top dog. Small-cap value shares have recently outperformed, stepping into the role held by large-cap growth stocks in the late 1990s. And though it has been quite a while, international shares had the top returns in 1993 and 1994, while fixed-income shares offered a 33% return in 1982 and an equally juicy 15% in '84.

Joseph doesn't use the chart to time the market, as no clear pattern has emerged over the past 21 years. Rather, she says, its randomness argues the need for an asset allocation that reflects an investor's risk tolerance. And, she says, the portfolio should be rebalanced annually to reflect the original allocation. So, in 1995 through 1998, investors would have pared away gains in large-cap growth stocks once a year, reinvesting them in segments that underperformed, such as fixed income, international and small-cap shares.

The same rotation can also be seen within industry sectors. Different sectors have periods of outperformance that eventually lead to periods of laggardness. Why? In part, the explanation lies in the flow of capital. As a sector starts to show positive returns, it captures the attention of investors who inevitably pour more and more capital into it. Unwilling to turn away easy money, companies use the cash to expand. As growth turns into overcapacity, returns slide into the dumpster.

It happened with energy stocks in the late 1970s, consumer stocks in the 'Eighties and tech and telecom in the 1990s. "It suggests there are no one-trick ponies," says Steve Galbraith, chief investment officer at Morgan Stanley.

Galbraith believes sectors that outperform and contribute an outsized portion of the earnings of the Standard & Poor's 500 index eventually will revert to the mean -- that is, underperform and return to their traditional level. To be sure, after the market's two-year downdraft, the discrepancies today are smaller than they were in the late 1990s. Still, Galbraith is cautious about the financial-services sector, which now accounts for 27% of the S&P 500's earnings, a level that has climbed steadily from only 7.5% in 1985. Likewise, the technology stocks could rise, because the sector has shrunk to represent about 5% of the S&P's earnings, down from a peak of 15% in 2000. Basic materials and health care also have room to grow and become an increasing proportion of the index.

Another area to watch: international stocks, which Galbraith considers undervalued on a price-to-book and price-to-earnings basis when compared to U.S. shares. "You're still being paid to make a bet overseas," he says. Conversely, investors may want to lighten up on Treasuries. Bonds have dramatically outperformed stocks and as investors searched for a safe place to hide. But if the economy continues to recover, 2003 could look something like 1994, when the Fed surprised investors by raising rates. "Treasuries are the least attractive asset class right now," Galbraith opines.

Again, the way to avoid buying at the top and selling at the bottom is to establish an investment plan and stick with it. For investors with an average risk tolerance, who are 45 to 50 years old, Joseph has some suggestions. She recommends putting about 50% of their funds in equities and the remainder in fixed-income and money-market funds. This is in addition to any real estate the investor owns.

She divides the equity component about equally between large and mid-cap growth stocks, small and mid-cap deep-value stocks and international growth and value stocks. The fixed-income portion of the portfolio will vary, based upon whether the money invested is taxable or tax-free. Taxable funds should be put in municipal bonds, while tax-free dollars can be invested in U.S. government and agency bonds, American corporate bonds and international bonds. Then remember to rebalance the portfolio.

"People should rebalance their portfolios at the same time every year, unemotionally," says Joseph. "This is not Las Vegas. It's asset allocation."

......................

The Ever-Changing Story

Large-cap growth stocks topped the market for four straight years in the late 1990s, leading some investors to believe this string of luck might go on forever. But as the chart below indicates, the rotation among asset classes, when it comes, can be swift and unforgiving - all of which argues that asset allocation, though much derided in recent years, remains a sound investment strategy.

see larger chart here....

http://www.suite101.com/files/mysites/je...

Subscribe to WSJ & Barron's Online @ http://www.wsj.com

....Jen

-- posted by Jen_

Top 12. Oct 19, 2002 10:37 AM

» capran - Re: Re: Dynamic Asset Allocation Works!

In response to message posted by Jen_:

Given the current interest rate situation and "bond bubble", it seems like investors needing to balance their portfolios would be better off having moneys they are going to designate as bonds money be placed in a money market until interest rates rise. if, in fact, bond funds will lose money as interest rates rise. is my thinking flawed here?

-- posted by capran

Top 13. Jan 12, 2003 9:46 PM

» 2win - asset allocation

Kirk,
Just noticed your e-mail from Dec. 10 suggesting we keep abreast of our asset allocation.

All my investments are in mutual funds. My portfolio is in two distinct parts: 1) tradeable, where I make exchanges about twice a month; and 2) intermediate-term IRA, where I make exhanges about every three months. During the last three years, at least 35% is usually left in a cash fund.

On Dec. 10, 22% of my assets were in the tradeable portion, while 78% were in the other.

ALLOCATION DEC. 10, 2002
Tradeable
Cash 32%
Gold 29%
Large-cap growth 19%
Bonds 15%
Small-Cap Value 5%

IRA Intermediate-term
Gold 45%
Cash 36%
Emerging Market 10%
Mid-Cap Value 9%

As of today, the tradeable part represents 21% of portfolio, while the Intermediate-term IRA hold 79% of my total mutual fund investments.

ALLOCATION TODAY, JAN. 13, 2003
Tradeable
Small-Cap Value 35%
Cash 23%
Large-cap Growth 26%
Technology 8%
Large-cap Value 8%

IRA Intermediate-term
Cash 34%
Latin America 32%
Gold 17%
Emerging Market 9%
Mid-Cap Value 8%

During 2002, the tradeable part lost .25%, and the other gained 89%.

-- posted by 2win

Top 14. Jan 12, 2003 9:59 PM

» 2win - oops! performance not quite that good

-- slight mistake on that 89% figure for my intermediate-term IRA performance. My records are incomplete, so that figure was way off. Actually, the gain was about 8%.

-- posted by 2win

Top 15. Jan 13, 2003 5:45 AM

» Kirk - Re: oops! performance not quite that good

.
In response to message posted by 2win:

Nice work! Few made money last year unless they have been "stuck clock" long term bears.

You sure have been right on Gold.

Did you add Gold recently (past few years) or have you been a long term gold bug who is now having your time in the sun?

-- posted by Kirk

Top 16. Jan 13, 2003 3:52 PM

» 2win - gold & Latin America

In response to message posted by Kirk:

I guess you could say I'm a reluctant long-term bear, not wanting to miss momentary rallies as they come. My interest in gold dates from the Y2K scare, when I wrongly expected a cataclysmic jolt to investor confidence would drive many to the safety of gold. That was a bad assumption, needless to say. But during the last year, gold has usually provided a good safety net, compensating for market downturns. So I'm not a long-term gold bug by conviction, but as a pragmatist have capitalized -- as well as lost -- on it. You'll notice my tradeable funds are out of gold now, since I locked in gains by moving to equities on about three different dates; and the exposure to gold in my intermediate-term has been reduced. When/if it comes down below where I sold, I'll try it again. Given the weakness of the dollar, I do expect gold to continue its upward trend.

As for Latin America, I feel there has been an overreaction to the election of the leftist president, Lula. American investors are scared to death of him. Unfortunately, that is true of the Latin America fund I chose.

But the new president of Brazil has too many alliances with moderates to make any drastic, menacing changes. His cabinet appointments and repeated pledges to honor foreign debt (and other market-friendly statements) are a bright green light for investors to take advantage of an undervalued market. Henrique Meirelles, a former president and COO of Bank Boston, is now president of Brazil's Central Bank -- (rough equivalent of the Federal Reserve Board).

If Lula had been elected on his first try, he would have been dangerous. But this was his 4th attempt. He has mellowed; his once-radically marxist philosophy has morphed into an innocuous hybrid one. He has brought new hope and optimism to Brazil, and I believe this will be reflected in Bovespa, their stock market.

-- posted by 2win

Top 17. May 21, 2003 7:19 AM

» Kirk - More on rebalancing

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In response to message posted by capran:

Kirks issue of rebalancing makes sense if you have a well balanced portfolio to begin with.

I didn't start out this way. I turned 41 in 1998 and that is when I believe one should start to add bonds to their portfolio as we are "getting too old" to have 100% in equities with "only" 25 years to the average retirement age. I took two years to slowly sell appreciating stocks to build up 20% in fixed income (Bonds, Cash, MM Funds & CDs) from about a 5% position in bonds & cash when I started.

I am of the belief that retired folks need two or three years of "no frills" living expenses in cash or short term bonds. That and a "balanced portfolio" make retirement much easier. Once you have critical mass, you really just want enough in stocks to keep you there with inflation. This varies from person to person but my estimate is 30 to 60 percent in equities will cover this for 95% of possible outcomes.

Had I done that every quarter in the falling market, because I was so over weighted in large cap and tech, I would have lost even more (as I would have moved my less losers into my greater losers and lost even more).

My technique explained in this article "Using Asset Allocation to make money in a Flat Market " only works well on the "simple level" if you are well diversified to begin with.

It is a different ball game if you pick stocks and over weight sectors. Here you need to pay close attention to valuation and GARP (Growth At a Reasonable Price). This can be equal mixtures of luck, skill and art.

If you are overweight to a sector such as tech, then it takes much more work to use my techniques, but they do work. My newsletter portfolio is about half in tech and yet it is about where it was in November 1999! By comparison, I think the overall market is down something like 40% since then! It took quite a bit of buying dips and taking profits when up to get those results.

If I didn't get fooled by WorldCon accounting, which had me too early in Agilent and others, then the portfolio would probably be even with its January 2000 levels! This is where the "luck" part comes into play as I was right on fundamentals for WorldCom and their suppliers but the fundamentals were "cooked" by dirty accountants and crooks. You just have to write that off as "bad luck" and continue on. This won't be the last time this will happen either.

Just hope the market doesn't do another summer time tank.

Me too, but the market will do what the market will do. I do think "the bottom" was last Fall (October 2002) but I have been wrong before and will be wrong again.

================== COMMERCIAL BREAK =================

As of 11/5/05 the Total Return for "Kirk's Newsletter Portfolio" since 12/31/98 is Up 173% while the NASDAQ is down 2%!!! (my portfolio beta is roughly equal to that of QQQQ.

For 2005, Kirk’s Newsletter is Up 5.0% YTD vs QQQQ up 0.4% YTD vs DJIA down 2.3% YTD vs S&P500 Up 2.1% YTD

-- posted by Kirk

Top 18. Nov 5, 2005 6:10 AM

» SteveT - Many Markets, Few Values

Many Markets, Few Values
By JACK ABLIN

JUST BECAUSE MARKETS get out of whack -- and trust me, they always do -- doesn't mean investment portfolios must also be out of whack. In volatile times smart investors strive to diversify as a means of reducing risk. History has shown the wisdom of such efforts: Allocating more funds to undervalued asset classes or markets, and avoiding expensive ones, not only can reduce risk but enhance long-term returns.

What's more, the opportunity to add value can be enormous, as the return differential between top- and bottom-performing markets can range from 25% to 75% in any calendar year. Over the 12 months ended Sept. 30, for instance, an investor who shifted 5% out of the Lehman Aggregate Bond Index, which delivered a 2.68% return, and allocated these funds to the MSCI Emerging Free Index, which gained 45.58%, would have picked up 2.15% in portfolio performance.

Shoulda, woulda, coulda? Identifying undervalued and overvalued markets is not as difficult as it sounds -- if you use the proper metrics. Take the so-called Fed model, thought to be favored by Alan Greenspan's Federal Reserve, which compares the earnings yield on the Standard & Poor's 500 stock index (12-month forward earnings divided by price) with the 10-year Treasury yield. Based on the difference between the two, the S&P was 70% overvalued as of January 2000, the market's peak.

I evaluate most markets from five perspectives, starting with fundamentals, which I gauge by comparing earnings and bond yields, or the market's price/earnings ratio relative to other markets' P/Es. Second, I study the general direction of the economy, which helps me determine whether or not we're in a conducive investment environment. The slope of the yield curve is a handy measure of investor expectations of economic growth.

Liquidity, the measure of ready cash available to propel a market, helps predict the market's capacity to advance. Comparing the year-over-year growth rate in the M3 money supply to the year-over-year growth rate of gross domestic product (GDP) is a good liquidity measure.

I also study investor psychology, or perceptions of the market, which has proven a good contrary indicator. There are many useful sentiment gauges, including the Consensus Index and Market Vane, which you'll find in the Market Laboratory1. If bearish sentiment has climbed to levels indicating investors wouldn't touch the market with a proverbial ten-foot pole, it's likely there is nobody left to sell. Conversely, if bulls abound, there may be no one left to buy.

Lastly, I analyze momentum. It is not enough for a market to be cheap, as cheap markets, like cheap stocks, often remain so, creating what is commonly referred to as a value trap. Momentum measures confirm that a market is moving in the right direction. If a market (or stock) moves above its 50-day or 200-day moving average, that's one good indicator of positive momentum.

I take a 12-to-18-month view of markets. Trying to predict the behavior of one market versus another on a quarterly basis is one step away from reading entrails. Short-term market moves are driven by investor psychology, which is often irrational. Beyond a year, market movements tend to respond more favorably to fundamentals and other measurable inputs.

So, where can an investor add value today?

I'm neutral on U.S. equities, as valuations are reasonable but the backdrop is dimming. The Fed model suggests the market could be as much as 20% undervalued, although subbing riskier BBB-rated corporate-bond yields for the 10-year Treasury yield suggests it's fairly priced. At the same time, future earnings -- the model's numerator -- are set to slow. The economic outlook isn't encouraging either. The Fed's moves to raise interest rates eventually will crimp growth, restrain retail spending and trim corporate profits.

The stock market thrives when the yield curve is steep and short-term rates are trending lower. At the moment, the opposite is true. Short rates are expected to more than quadruple to 4.25% by the end of this year from their low of 1% in June 2003. Meanwhile, on the longer end, the difference in yield between two-year and 10-year Treasuries has declined from 1.55% to 0.15% over the past 12 months.

Typically, the Fed takes rates too high, precipitating a financial crisis and a flight from risky assets. It is precisely when the crowd has given up that valuation and economic measures begin to turn attractive. The time to buy stocks aggressively will be when momentum turns positive. For now, valuations are reasonable enough to support my agnostic view of the asset class. But if interest rates rise substantially or profit expectations falter, I would scale back my equity exposure.

Within the equity market, small-capitalization stocks, as represented by the Russell 2000, have outpaced large stocks (the Russell 1000) by more than 43% over the past five years. While large-caps' underperformance was justified from a valuation perspective, the scales are tipping toward the big guys again. At the outset of the small-cap rally, the P/E of the Russell 2000 was a full eight points below that of the Russell 1000; now, small stocks trade at a 15% premium to their larger brethren.

Consider the circumstances, such as easy credit and a strong dollar, that long favored small-caps. Credit is tightening, and investors are beginning to require a higher yield premium to lend to lesser-quality issuers. Large-cap companies usually enjoy easy access to the credit markets, so they would gain a relative advantage here.

Too, large companies tend to be exporters, while smaller ones generally stay home. Dollar strength has hurt the market's largest issues, but it's likely the buck will reverse course as the Fed's rate-raising regimen ends. Momentum is beginning to confirm the sectors' reversal in fortune; since the start of August, small stocks have underperformed by more than 3%.

S&P Depositary Receipt (ticker: SPY), is an exchange-traded fund representing the S&P 500. iShares S&P 100 (OEF) represents about 57% of the market cap of the S&P 500. Both ETFs afford a low-cost way to play the large-cap market.

Looking abroad, developed international markets, as represented by the MSCI EAFE index, are reasonably valued relative to the S&P 500. The broad foreign index trades at 16.7 times trailing earnings, a 7% discount to our market, and at 2.3 times book value, a 21% discount to the S&P. EAFE earnings are expected to grow by 10%, S&P earnings by 12%.

On the economic front, global central banks are somewhat more accommodative than our ever-tightening Fed. Since monetary accommodation is more conducive to an equity advance, score one for the foreign marts. That the EAFE has gained close to 6% in a year in which the dollar has rallied against most major currencies further signifies the strength of international markets. Should the dollar weaken, as it's likely to do, the EAFE markets would enjoy a tailwind. iShares MSCI EAFE (EFA), a widely traded ETF, is a good way to play these markets.

Emerging-market equities remain attractive on an absolute and relative basis, in spite of their impressive gains over the past three years. They trade at a 25% discount to their U.S. counterparts on a price-to-earnings basis, and at a 26% discount on a price-to-book basis. While current emerging-market valuations are higher than historical trends, the underlying credit quality of economically emergent nations has improved markedly. Considering more than half of emerging-market economies have attained an investment-grade credit rating, current valuations are well within reason.

Liquidity firmly supports these stocks. Cash flows into emerging-market mutual funds have been largely positive since early 2003. Too much hot money can be a cause of concern, however, so this is a condition worth monitoring.

The moves we've seen in emerging markets likely are part of a multi-year revaluation relative to the U.S. market, and are apt to continue as investors search for incremental value and return. Exposure to this sector can be attained through iShares MSCI Emerging Markets Index (EEM).

Leaving stocks, I continue to hold commodities, a position I added two years ago. But I expect we're in the eighth or ninth inning of the commodity cycle. Unlike all of the other markets I track, commodities possess no fundamental value. Since coffee doesn't offer investors dividends or earnings, there's nothing to discount to determine its current market value. Therefore, we need to rely more heavily on the economic environment for clues.

The real rate of Treasury bills is a valuable metric for commodities, as short-term investors have a choice: they can invest in real assets (commodities) or financial assets (Treasury bills) to protect their purchasing power over time. When T-bills yields are offered sufficiently above the rate of inflation, financial assets will adequately protect purchasing power. But, when T-bill rates are set below the rate of inflation, as they were at the end of 2001, real assets will do a better job.

From the fourth quarter of 2001 through September of this year, T-bill yields were below the rate of inflation and the Dow Jones AIG Commodity Index advanced more than 90%. By year end, however, short rates are likely to top inflation, creating an advantage for financial assets. Our bet: the commodity cycle will end at the close of 2005. There is no ETF that tracks the Dow Jones AIG Index, but the Pimco CommodityRealReturn Strategy Fund (PCRDX), which combines inflation-indexed Treasuries and derivatives, is a decent proxy.

Investors can hold expensive assets as long as their value keeps growing. The minute a market loses momentum, however, it's time to pare your position. Think of a market cycle as a clock, where six o'clock is the bottom and 12 o'clock is the peak. Using metrics will help you get in at 7:00 and out at 1:00.

JACK ABLIN is chief investment officer of Harris Private Bank in Chicago, which oversees $44 billion in assets for individuals.

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-- posted by SteveT