Value Portfolio: Global Asset Allocation Analysis

Global Asset Allocation: Monday, August 15, 2016

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Significant Changes Since Last Week:

Welcome to the first asset allocation analysis report. This report will be produced monthly, on the 15th of each month and take into consideration changes within relative fair values, interest rates and corresponding yields as well as forecasts for each identified classification listed in the table. The table provides target allocations in terms of percentages that would ideally reside in each category. (I say ideally because real life portfolios must take into consideration taxes and other assets that are part of an individual’s investment program.) The percentages act as a guide to determine where new cash should be deployed, where possible gains should be harvested and where allocations are moving away from targets so that corrective action can be planned. Asset allocation is a long term management tool and not something that should be forced or mandated, it is a roadmap.

Since this is the first report let me provide some definitions and explanations in regards to what is currently influencing the table. Asset classes are divided between three major categories: cash, bonds and stocks. Each major category has several secondary categories. In bonds there are eight secondary categories:

  • U.S. government bonds (US Govt)
  • Mortgage Backed Securities (MBS)
  • Corporate Bonds and Preferred Stocks (Corp/Pfd) as a single secondary category
  • High Yield Corporate Bonds (HY Bonds)
  • International Corporate Bonds (Intnl Corp)
  • Municipal bonds (Muni)
  • Sovereign debt bonds (Sov Mkt)
  • Emerging market bonds Emerg Mkt).

The stock category has several secondary categories: Largecap, Midcap, Smallcap and International. The Largecap and International stock secondary categories have tertiary categories.  Largecap is divided into the ten sectors as defined by Standard & Poor’s and International is further segmented into the respective categories used in the FT/MSCI series of index classifications: UK, Europe, Pacific, Japan, China, Africa and Emerging Markets.

The table columns are organized in relationship to what an investor may wish to accomplish in any specific portfolio. They range from high levels of stability (left side) to a high level of future opportunity (right side).

The industry has traditionally used this area of allocation as a starting point and many times an overpowering or dominate mutually exclusive decision. Traditional allocations were also developed under an absolute position that higher yields move in-lock step with higher risk. However, with constant quantitate easing, known as QE and now negative interest rates as a reality, not just theory, risk has had to take on the acceptance, or not, of definite diminishing value over time. What good is stability if the result is a near absolute guarantee of negative return?

Asset allocation must now address probabilities of negative value as part of the design rather than just the esoteric experience of “volatility”, “unfavorable market” or “style out-of-favor”. The current environment has moved beyond fixed statistics and must now embrace the varying probability of future opportunity, both positive and negative.

The allocation table incorporates these probabilities and changing conditions. It attempts to provide guidance within the current and future investment environment in terms of outcome probability.

In the table a Stable target speaks for itself in that the outcome of the asset allocation will be a value level with a reasonably high probability of outcome within the premise that the investor wishes to maintain a consistent value in the overall portfolio. The asset allocation suggestions within this table do not accommodate an investor that wishes, for some reason, to deliberately lose value for stability. While there is never a guarantee that values will increase, the information contained in the table is considered the best recommendation given current market conditions and expectations.

As you move to the right across the top of the table stability is reduced and a corresponding increase in the potential for future value (opportunity) increases. Future opportunity is achieved through increasing levels of stock within the portfolio. You can see that the stock allocation moves from a low of 10% when attempting to retain a level of stability to 100% as opportunity becomes more desirous.

At this point I would like to focus on some of the themes within the asset allocation process that take into consideration current economic environments around the world and some construction factors of the markets. In bonds, due to current market conditions and expected future conditions, the allocation is exclusively made to corporate bonds and preferred stocks. Preferred stocks are classified the same as 30 year corporate bonds because of their design. They generally trade near $25/share, par, and do not mature unless called within the provisions of the issued security. For an investor, 30 years is an investment horizon usually reserved for bonds and not stocks. Therefore, preferred stocks are aligned with corporate bonds for asset allocation.

With over 20% of the world’s government associated debt providing a negative return we have consciously made a zero allocation to these areas. This includes: U.S. Government, Mortgage Backed Securities, Sovereign Market and Emerging Market. Currently, if bonds in these categories are of high enough quality the yield is anemic and if the yield is high enough for consideration, the probability of non-payment, or eventual “restructuring”, (see default for an explanation), is too high. Municipal bond yields are so low now that unless you are in the absolute highest tax bracket, buying new municipal bonds places the security in a potential loss of value proposition either through after inflation buying power or risk of holding an unmarketable security if interest rates move up. High yield corporate bonds are in a similar situation in terms of marketability if interest rates move upward. Corporate bonds and preferred stocks are the closest bond category that provides yields that represent traditional bond yields (pre-1990) and security.

If interest rates change and return to normal levels, bond allocations in the table will be adjusted to reflect current and expected bond market conditions. However, past Federal Reserve Chairman Ben Bernanke stated that he did not expect to see “normal” interest rates at the central bank in his lifetime. He is 62. Many portfolios currently hold large amounts in bonds. These were most likely added during times when yields were reasonable and they still are providing stability and good income. Holding these to maturity is reasonable. As bonds mature in the portfolio they would be reinvested in corporate or preferred bonds if appropriate or possibly reallocated to dividend paying stocks at this time. Under current market conditions stock asset allocation, not just bond allocations become increasingly important in generating value in terms of both dividends and future value.

Stock allocations are divided amongst domestic and international markets. American listed companies generate, on average, one half of their revenue through international activities. This has increased over the years and is no longer a unique condition of Largecap companies. To take this into consideration, we have adjusted the allocations within each sector and international region to reflect the global nature of the representative companies within each sector. If this adjustment is not made it would be easy to over allocate to a foreign market.

Allocation between the 10 sectors is made according to the sectors relative value (under, fair, over). Undervalued sectors present a higher probability of adding future value than overvalued or fairly valued sectors therefore undervalued sectors receive a relatively higher allocation above the market allocation. Overvalued sectors have a higher probability of not growing as fast or possibly declining relative to undervalued or fairly valued sectors and receive a relative lower allocation than the market allocation.

The first five categories across the top of the table, starting with “Stable Target” moving through to “Opportunity Target”, range from a focus on stability to a focus on future opportunity. The last column on the right labeled “LargeCap Only” is for investors that wish to only invest within the domestic Largecap universe of stocks.

The allocations in the table will change slightly over time as stock relative values change and create over and undervalued conditions within the respective sectors. These are not static allocations nor are they volatile; they are more trend orientated. You will see over time slight increases as sectors and markets as they become over and undervalued. These changes will reflect long term trends. They are not short term “trading” based ideas but based on longer term value producing market conditions. Please keep in mind the table is a guide for future allocations and adjustments.

Each month differences between reporting periods will be highlighted along with explanations as to why changes were made in each area. Our objective is to add to your understanding of what is occurring within the economy and market that matters to a portfolio and not just headline news or daily hype.

Keep in mind every portfolio is different and this is a guide to understanding why changes might be considered and why. It is not an absolute arbitrary demand. Each person is an individual with their own set of circumstances and history which must be taken into consideration.  This is NOT a Specific Recommendation and Should Only Be Viewed as  News Based Information for Your Consideration

By | 2016-08-15T15:04:53+00:00 August 15th, 2016|Categories: Money Basics|0 Comments

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Articles attributed to "Guest Contributor" are written by former employees or invited guests. Contents are for your consideration only The opinions expressed herein are those of the authors and do not necessarily represent the views of Charter Trust Company. Nothing contained in this communication should be construed as investment advice.

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