Asset Allocation for 2007
Insight NewsletterIssue #09
As 2006 draws to a close, it’s becoming increasingly lonelier to wax skeptical on the stock or bond markets. The year is closing out with a bang, with equity indices up 12 to 20 percent, and bonds posting solid high single digit gains. Commodities have also done well, but fears of an economic slowdown increase the odds of slacking demand and lower commodity prices. Meanwhile, a real case can be made, that the investment risk premium (the amount of return required for taking on risk) has truly declined. In other words, the historical price to earnings ratio (PE) of 12-14 is no longer an accurate benchmark for fair valuation. This new economy of a global economic world seems to warrant sustained higher valuations and lower-average interest rates.
Global capital seeks an allocation in less risky environments. What do I mean? I mean that now that now that there is significant new capital accumulation in India, China, Russia, parts of South America, and the Middle East Oil States, the quantity of capital that is seeking an allocation in stocks and bonds in the stability of western economies, is much larger than before. This in course is creating more permanent demand for equities and bonds. At the same time, the volatility of the economic cycle has declined, as manufacturing, the most cyclical part of modern economies, has been outsourced to the lesser developed economies, making the economic upturns and downturns of the more advanced economies for less severe. Less severe economic cycles means that investors require smaller risk premiums. Smaller risk premiums are the recipe for higher valuations (PE multiples). In this seeming plateau of permanently higher valuations, we fear for our clients’ accumulated wealth, because, this thesis of permanently higher valuations may prove, in the fullness of time, wrong.
What does all this economic gibberish have to do with Asset Allocation you ask? Unfortunately, everything. If the brave new world analysts, market strategists, talking heads and investment newsletter writers are correct, then the world really is different this time. It is a global economy, and the deep value thesis’ of Graham and Buffet are truly old-school and out-of-date. That old school point of view just kept you out of the market this year, and the fantastic 15% rise in equities over the past 6 months. And give the new school its due; since 2001, the rise in S&P 500 earnings has been truly extraordinary. Reported Earnings per Share (EPS) of $24 (after $14 of accounting write-offs) in 2001 rose to $70 in 2005 and should come in around $77 to $80 this year. In other words, real corporate earnings have risen more than 200% in the last 5 years. That’s a lot. So the question is: are we at peak profit margins, or are peak profit margins indefinitely sustainable?
The answer to this question makes all the difference in the world. If Labor’s growth in income is going to continue to grow at 3 to 4 percent, while corporate profits continue to grow at 10%-15%, then it sure is silly to not be heavily invested in stocks. The reason to believe that we should underweight stocks is because we believe that labor is due – that labor costs are going to begin to rise faster than profits and that corporate profit margins can not remain on a permanent high plateau. The pendulum between capital and labor is a permanent fixture in the economic system, and it defies common sense to bet that Capital has won a permanent victory over labor. Human nature isn’t that way, the pendulum almost always swings back, sooner or latter.
Please look at the archives of Paul McCulley at PIMCO on the eternal struggle of democracy, the tug of war between capital and labor, the role of the Federal Reserve as the arbiter of democracy and capital, and other musings at www.pimco.com. The August and December 2004 readings address the theoretical underpinnings of this debate well.
So what’s going to help Democracy (labor) increase its take home share of the corporate pie. Well some classic inflation variables have begun to get the ball rolling (rising food prices, healthcare, energy), babysitters that disdain less than $10 per hour, – hey, that’s my leading indicator, if today’s teenagers expect $10 per hour, what are they going to expect in 10 years? And it may be 10 or more years, that’s a risk (witness labor’s defeat at the automobile companies and in the airline industry), before labor can gain the upper hand.
The global economy is still reeling from the industrialization of Asia. So many new entrants into the labor market, to the tune of 500 million over the next 10 years or so, make it very difficult for US workers to achieve real wage increases, despite enormous corporate liquidity (company balance sheets are filled with cash). Until the domestic economies develop in Asia, and the mass exodus from the rural country to the cities, subsides, the difficulties of labor to achieve real income gains will persist.
But when the tide finally turns, and labor (democracy) begins to get real wage increases, the wheels are going to come off the equity cart. The risk to being heavily weighted in equities, is that if labor costs have a sustained rise, greater than their productivity gains, then corporate profits are going to decline, P/E multiples will decline, and the bear market in stock markets will resume in force. That’s the risk. It might not happen, or it might not happen for a long time. The forces of the global economy may be so great, to have rendered the historical averages of stock market history over the last century to no longer being meaningful. But as fiduciaries, we are in the capital preservation game, and we are convinced, that it just doesn’t make sense to error on the side of more risk. While Wall Street is advocating 60% equity allocations, we will draw the line at something between 30% and 50% for most balanced Baby Boomer portfolios. Now the Gen-X’rs can take on a bit more risk (those born between 1965 and 1975), if their jobs and expenses are very stabile, but few of Generation X can claim that. And much of Gen X is so skeptical and seemingly risk adverse, that lower equity allocations are probably better for them anyway. Read why at wikipedia.org.
This letter is getting long, too long, so let’s cut to the chase.
For 2007 we reiterate much of our 2006 stance: equal weightings between international and domestic equity positions should not to exceed 20% each in most portfolios, cash positions of 15% to 30%, 20% to 40% in Alternative Asset classes, including tangible assets, particularly precious metals, and metals and mining stocks. We advocate an overweighting in Energy and Healthcare sectors. On the fixed income side we see average allocations of (10% to 25% – not including cash). We moderate our bearish stance in fixed income, because we believe that an economic slowdown will lead to some lower interest rates for a few years. We have recently seen some attractive longer-term corporate A-rated paper paying over 7%, and intermediate municipal bonds in the 4% level, and we are more inclined to take on more term risk than we were at the same time last year because we believe what the bond market has been shouting. It has been saying that rates are coming down, so we are locking in some yields clients in some longer term paper.
In the next issue of Insight, we will review 2006 and give our ‘07 Outlook including 10 predictions for 2007. We trust that most of our predictions will be wildly inaccurate, but gosh, we need to have some fun too! We like to remember that our business isn’t too much different from shooting baskets or hitting a small ball going 90 miles per hour, if we can do it well, 1/3rd to 1/2 of the time, our client’s returns will be very good indeed.
Our next letter will come out around January 3rd. Have a great time with friends and family in the coming days!
Daniel Barnes, CFA