It's Time To Reconsider Your Portfolio Strategy

by: Chris Weale

Part 1: Introduction

This article is my analysis of the current macroeconomic environment and its effects on the markets. I make explicit predictions based on assumptions that may not be fully comprehensive and may change with new information. My analysis is focused on the short to medium term (1-5 years) and is designed to help long-term investors construct a portfolio allocation that is consistent with their investing goals.

The purpose of this article is to share my opinions about the market environment looking ahead 1-5 years, and to recommend guidelines for investors to consider in terms of portfolio asset allocation. The point is not to tell investors what their allocation should be, but instead to provide information and advice to help investors decide for themselves what allocation is appropriate for them. Although I do recommend a specific allocation at the end, it is only to illustrate my predictions of which asset classes and industries will outperform, and how much exposure is consistent with those predictions.

Because of this generality I do not suggest specific investments to add to your portfolio. Also, depending on your investment style and goals, the allocation I suggest may or may not be entirely appropriate. Although the information here can be used by all types of investors, it is primarily for investors who understand the global macroeconomic environment, are self-directed in their portfolio management, and want to beat the market without paying fees to fund managers.

One more thing to note is that I am not particularly fond of ETFs for most types of equity exposure, especially for those with large portfolios and the ability/resources to find specific investments. As a result of this, suggesting specific investments for my example allocation is beyond the scope of this article, and will instead be addressed in future articles.

The following report will be broken down into 3 sections. In part 2 I will discuss Fed stimulus and its relationship with market performance, in part 3 I will analyze the global economy, and in part 4 I will discuss the implications of my opinions and suggest actions to take in terms of allocation in your portfolio.

Part 2: Fed Stimulus and Market Performance

This recent market rally has been an interesting one. Although the actions of the Fed are not supposed to be guided by financial markets per say, it certainly has taken a deep consideration of them with respect to its behavior.

This strange market rally in the S&P500 since the start of QE3 has been driven mostly by the effects of a prolonged low interest rate environment. The primary reason for lowering interest rates is to stimulate aggregate demand through business investment and consumer spending, but has had only a minor impact on both. Instead we have businesses with cash they are unwilling to invest, banks with deposits they will not lend, and consumers spending instead of saving. The respective charts below illustrate these points.

The prolonged low interest rate environment has led to a rally in equity prices mostly because of simple supply and demand, as there has been no better use of capital than placing it in equities for now. Sure, business profit margins have expanded significantly, but that's not because of investment into productivity improvements but instead mostly because of cost-cutting measures such as layoffs. The first chart shows S&P 500 profit margins compared to sales growth, and the second one shows net profit margins in general.


If you still don't believe me, just look at where the rally in equities has been. In a typical market rally based on economic and business fundamentals the top performers are cyclical industries that earn lots of money when people and businesses are spending and investing more than usual. Instead of this we have equity prices in the aggregate rise when economic data turns out worse than expected as investors buy the defensives and the high yields because of the reassurance that accommodative monetary policy will continue.

This suggests that there hasn't really been a market rally at all since at least the start of QE3, but rather a hefty and extended "premium placement" on securities that have seen an influx of demand. This demand has been essentially artificially and temporarily created by yield-starved investors bidding up income producing assets and cheap money for financial institutions. This latter is illustrated in part by the rally in home prices, which has been driven more by institutional buy-for-rent investors than by consumers purchasing homes to live in.

Now we are in a strange situation where historically strong correlations are tossed aside in favor of Fed-speak. If central bank easing is withdrawn or tapered, the giant premiums placed on the securities that have rallied simply because they produce a yield will be removed. This was illustrated by the large haircuts in the high yield bond and REIT indices the Wednesday Bernanke said stimulus could begin to be tapered earlier than previously anticipated. This places downward pressure on equity prices as a whole because the S&P has become overvalued because of these premiums placed on certain sectors. This is why good economic news lowers the index as a whole, because the rise in value of companies due to improving fundamentals is less than the amount of premium removed from the "nowhere else to go" phenomena being removed. The net result is a decrease in the S&P 500 index.

This does not mean that bad economic news will continue to be good for equity prices or that good economic news will continue to be bad for equity prices. If economic data improves to a point where stimulus is no longer necessary, the fundamental value of businesses should increase enough to offset the removal of the premiums placed on sectors that rallied because of low interest rates. If economic data gets worse to a point where stimulus needs to be increased, equity prices should suffer as businesses make less money.

So what will happen with stimulus? Let's start with a premise and then look at some more charts.

The Fed will not remove stimulus until explicit unemployment and inflation targets are met, which will not happen for a long time.


- This chart shows that unemployment numbers are trending downwards, but at a diminishing rate.

- This second chart shows that the number of unemployed people is hardly decreasing, and suggests that an increase in the participation rate could push the unemployment rate higher.

- This third chart shows the employment to population ratio, which shows that job growth is barely keeping up with population growth.

Source: Bureau of Labor Statistics


- Deflation is still a large concern for the Fed. The deflationary pressure from the collapse of global credit in the great recession crippled the financial system's collective balance sheet to which it still hasn't recovered from. Perhaps the Fed buying $45B in mortgage-backed securities every month has as much to do with fighting deflation than it does with suppressing medium and long-term interest rates to stimulate the economy.

- The chart below illustrates the inflation rate since the start of 2008.

- Another indicator of inflation is the velocity of m2 money supply. The velocity of money measures how much an average unit of currency is spent in the economy. A high velocity of money means more spending and investment is occurring and therefore more economic activity, and is generally associated with higher inflation. The chart below shows that the velocity of money in the US economy is at the lowest levels in modern financial history.


So if the unemployment and inflation targets are probably still very far away, why all this talk of tapering? I believe the Fed is pretending to taper in order to prevent speculative bubbles from continuing to develop in certain sectors of the market.

As I mentioned before, the Fed is interested in more than just the economy and is actively trying to influence markets. The Fed knows the reasons behind this market rally and would like to see certain sectors cool off without a panic driven sell-off. I believe the economy is not yet close to being ready to remove stimulus, but that the Fed will allow interest rates to move slowly upwards because it must do so in order to prevent asset bubbles from continuing to form, and because it is simply not able to convince investors that interest rates can remain this low forever.

Part 3: The Real Economy

Economics is supposed to be the driver of market performance. When the economy does well that usually means businesses are growing and more economic activity is occurring, and when businesses become worth more money their stock prices rise. Even though it seems like economic data is doing precisely the opposite, this is just an illusion hidden in the details. Good economic data still helps most businesses, but the withdrawal of stimulus results in the removal of the premiums that are in place, and this premium removal currently tends to exceed the rise in fundamental value of companies. That makes the S&P 500 as a whole move lower even though fundamentals are improving.

So now that I have established that the economy is actually important for stock prices, let's explore how the global economy looks.

1. Global economic data is discouraging

Global GDP growth depends highly on Chinese demand. If China is in as bad an economic situation as is currently being priced into its markets, this will seriously weaken global growth.

- The first chart below shows the diminishing growth rate of China GDP, and the second chart shows the performance of Chinese equities since 2010.

Chinese SSE Composite 2010 - 2013

There are many who believe China is in serious trouble. As if the official data wasn't suspicious enough, China has now gone so far as to stop sharing some of its PMI statistics.

It just may be that the stimulus into infrastructure and real estate for decades and the ensuing bubbles, made clear by the abundant "Ghost Towns," may begin to deflate. This would mean monetary and possibly fiscal tightening, without which could put the entire Chinese financial system at risk. This tightening, as far as the world is concerned, means significantly less demand from China, particularly for materials and energy.

Of course, global demand isn't just China. So who else do we have? The rest of the developed world isn't expected to grow even as fast as the US (except a few small economies), and emerging economies, as far as markets are concerned, look even worse.

- The following 3 charts show EU GDP growth rate, Japan GDP growth rate, and the MSCI emerging equity index, respectively.

MSCI Emerging Markets Index Fund (NYSEARCA:EEM), source

2. US economic data is also weak, but looks good relative to other developed economies

- The GDP growth is among the highest in the developed world, although in absolute terms is still pretty lousy.


In conclusion, I am predicting sluggish global GDP growth. Despite the challenges facing China, emerging economies, the EU, and Japan in particular, I do not predict any major new economic surprises to meaningfully lower the already modest projections of global GDP growth. The global economy is still fragile enough where stimulus is needed, but strong enough where another recession is unlikely. Unless some major shock event happens in a major economy like China, Japan, or the EU, this sluggish recovery dependent on stimulus is destined to continue.

Part 4: The Implications, and how to Position your Portfolio:


1. Expect rates to "normalize" very slowly, AND stimulus to continue simultaneously.

- The weak economic data as discussed in the previous sections will not permit the withdrawal of stimulus, so rates will still rise very slowly as the Fed continues to signal to the market that stimulus will eventually be withdrawn. As I stated before, I believe this is to prevent bubbles from continuing to form in certain sectors.

- The premiums placed on sectors that rallied purely because of low interest rates and QE will eventually be removed, and these sectors will underperform over the long term even if they continue to gain in the short term.

- Dividend growth companies in all sectors that have competitive advantages and are trading at or below fair value are still attractive in this low rate environment from a risk/reward perspective because they benefit from both a strong economy and stimulus.

- Rising interest rates will benefit some financial companies. Depository institutions, life insurance companies, and investment services companies should benefit as they earn higher loan margins, bigger investment returns, and more fees. Another investment type that typically outperforms the markets when rates go up are business development corporations (BDCs) that invest into small and mezzanine sized business in a variety of creative ways.

2. Volatility will not continue trending downwards for much longer

- The Volatility Index (VIX) tracks expected volatility based on the implied volatility of option premiums for all the stocks in the S&P 500. It essentially measures how risky investors believe the market is based on what prices they are willing to buy and sell options at. Generally there is a negative correlation between the S&P 500 and the VIX, and volatility in the markets tends to increase in times of economic uncertainty. Many investors buy VIX products to hedge against volatility in the markets, and many traders buy or sell them just to speculate.

So why do I think volatility will stop decreasing? Because the VIX is calculated from option premiums of the S&P 500, the level of uncertainty regarding US companies is what determines the expected volatility. As the global economy and business revenues continue to struggle to grow, profit margins stop expanding, QE begins to be tapered, and interest rates begin to rise, the outlook for US companies will become less certain. This uncertainty, although it may not lead to a reversal of the current bull market, will result in more volatility in stock prices and at the very least a temporary reversal of the VIX.

As you can see in the chart below, periods of declining volatility only last for so long, and when the VIX increases it tends to happen quickly. This is shown by the lengthy descending wedge patterns that once broken through to the upside proceed to head much higher very quickly. For those of you who care about technical analysis, the 14-period RSI on a monthly chart has predicted the past 2 breakouts and I believe will predict the next. So I'm not saying that volatility is about to spike now, I'm saying I wouldn't count on it continuing to trend downwards for another 5 years. Eventually it will stop trending downwards and we will be in a period of rapidly rising volatility.


3. Emerging Markets look cheap but will continue to underperform.

- MSCI and FTSE emerging market indices are at lowest levels since October 2011.

- The tapering threat has devastated both equities and fixed income in emerging markets far greater than in the US. With the tapering threats likely to continue to prevent speculative bubbles, this type of volatility will continue in these markets.

- On the other hand, according to Morningstar research, investors seem to disagree. Morningstar data on mutual fund flows shows that investors are still flocking to international equities, with diversified emerging market funds leading the way with a whopping $23.6 billion inflow YTD of the total $66 billion inflow into international mutual funds. Clearly, US investors are bullish on emerging market equities despite the economic challenges they face. My speculation on this pattern is that most US mutual fund investors are long-term investors, and emerging markets currently appear to offer more value and higher potential returns over a 20 to 30 year time period. The latter may be true, but because they are likely to underperform in the short to medium term, my view is that the exposure can wait.

- Data through May 31, 2013. Source: Morningstar Research

4. Materials and energy sectors will continue to suffer

- The story here is China. Because much of the growth in China was led by real estate and infrastructure development, which is now severely overheated, the demand for inputs from China will fall as the sectors cool down. Monetary tightening is the probable action, although for now this tightening is not certain, and it's not priced into markets yet. When/if it happens not only will Chinese equities as a whole take a nosedive, but their demand for materials and energy will also.

- Emerging markets also make up much of the demand in the materials and energy sectors. As the emerging countries economic situation continues to deteriorate as the pricing of their equities seem to suggest, the demand for materials and energy is looking increasingly bad.

- The growth in natural gas and oil supply from new exploration and extraction techniques is another headwind for the energy sector. There probably isn't near enough demand to offset the price reducing effects of the supply increases, which is a trend that doesn't seem to be going anywhere anytime soon.

5. The US is the most attractive place to invest

- Compared to the rest of the developed world, the US has the best economic and business outlook. But Unlike the previous 6 months or so where the rising tide lifted all boats, picking the right investments is now far more important than simply being in the market.

How to position your portfolio:

1. Trim and adjust income investment exposure

- Replace high yield stocks and REITs with dividend growth companies. REITs in general should continue to have modest gains in this low rate environment, but there is very limited upside remaining and gains will continue to be dependent on the "nowhere else to go" factor. In terms of high yield exposure, REITs are probably your best bet. Just make sure to avoid mREITs and other highly leveraged REITs who will face challenges when interest rates go up.

- Replace high yield and government bond exposure with investment grade corporate bonds. I actually suggest eliminating high yield and government bonds entirely. These sectors, like high yield stocks, also have very little upside remaining and significant downside. Investment grade corporate bonds are also expensive, but present the best risk/reward of essentially all fixed income investments. I also suggest international diversification for this exposure.

2. Trim defensive holdings

- As I mentioned before, defensive stocks are overvalued and have little remaining upside because of the premiums that are priced into them. This does not mean they will underperform, however. This is because they still benefit from good economic news, but this is more than offset by the removal in the premiums placed on them. This means for now they will suffer or trade flat with an improving economy and increase with bad economic news and increased stimulus and further "premium placement." It is for this reason I recommend maintaining some exposure, but for most investors this means reducing it.

3. Adjust exposure to financial sector

- Trim the high yielding dividend payers and the overvalued defensive financials in favor of firms that will benefit from rising interest rates. Depository, life insurance, investment services, and BDCs are some examples, but any financial institutions that have strong balance sheets and competitive advantages should continue to perform better than the broader financial indices.

The financial sector in general is still an attractive place to be. Compared to historic valuations they appear at relatively fair value, and most of them offer a decent yield as well. This is why I recommend adjusting, and not necessarily decreasing exposure.

4. Hold US cyclical and technology stocks

- Not all cyclical stocks will perform well as the markets adjust to the macroeconomic changes I am predicting. Cyclical stocks in the heavy equipment industry will obviously behave differently than cyclical stocks in the housing industry, for example. Picking the right cyclical industries to enter into is very important.

The cyclical industries that should do well are the ones that do not rely on demand for materials and energy, and that have not been bid up to valuations that no longer make sense. Cyclical industries like home construction and tourism that are highly dependent on consumer confidence should perform well, as well as industries that depend on business confidence and increased investment. Because the US economy is looking better than the other major developed economies, US cyclical stocks will be the biggest beneficiaries of this growth and least likely to be harmed by unfavorable global economic factors.

- The reasons I am bullish on US technology stocks, excluding of course the big names that act as defensives as well, are very similar to the reasons I am bullish on certain cyclical industries. The US is the best-developed economy to invest in, and many technology stocks are still trading at fair value. These companies should realize the benefits of a modestly improving economy and be less subject to the risks of global economic challenges than international technology stocks that are more dependent on other developed economies.

5. Reduce materials & energy exposure

- As I stated before, these sectors will probably continue to perform poorly, as the demand from China and other emerging economies falls while supply of energy rises. Although the sectors are trading at a big discount right now they have not yet priced in all the uncertainty surrounding the Chinese economic situation and are highly vulnerable to any data that suggests Chinese demand will fall. Although this vulnerability also means they would benefit from the opposite type of data, this seems unlikely. There will be lower risk opportunities to beef up on the materials and energy exposure later when the dust has settled and the volatility goes down. The materials and energy sectors are, in my opinion, a value-trap right now, and I expect further declines before the bottoms are reached.

- As for precious metals, I expect increased volatility. The dynamics of the gold market are very psychological and complex, and so I do not like to make investments into gold directly. I do not have an explicit prediction for the price of gold, but I do predict an increase in volatility, which in my opinion is justification for reducing its allocation in your portfolio.

6. Add global infrastructure exposure

- When global GDP growth is slow governments around the world often turn to infrastructure projects to stimulate their economies. Although China is essentially doing the opposite, emerging countries that have previously had robust economic growth and no need for stimulus will begin to implement these types of infrastructure projects to avoid recession. Finding the right countries to invest in is important, however, because for many emerging countries these infrastructure projects would not make sense and would not help the economy grow. Economies that have had high growth rates without government infrastructure stimulus that are now struggling economically are the best candidates for infrastructure investment.

7. Carry cash

There are many reasons to hold a larger than normal amount of cash right now. In my opinion, cash has never been more king.

- The USD is likely to continue to appreciate against other major currencies. The demand for the almighty petro-dollar is only going to increase as the rest of the world continues buying USDs to enter US markets. Significant uncertainty in the global economy also propels the USD as a safe haven asset in times of global crisis, should one happen again. Furthermore, the debasement of other major currencies like the Japanese Yen and the Euro, as well as the decline in demand for commodity currencies like the Canadian and Australian dollar will also have a positive effect on the USD.

- Cash reduces portfolio risk. In times of economic uncertainty it is rational to hold a larger than normal amount of cash to both avoid the effects of volatility and capitalize on opportunities that develop from it.

Example Allocation to Work Towards:

7.5% Cash/cash equivalents

10% Fixed Income

  • 7.5% REITs
    • 5% commercial/industrial
    • 2.5% residential/MBS's
  • 2.5% low duration investment grade corporate bonds

82.5% Equities

  • 25% US cyclicals
    • 10% homebuilders
    • 7.5% industrial/heavy equipment/manufacturing
    • 5% travel/tourism
    • 2.5% transportation
  • 15% US technology
    • 5% large cap/dividend growth
    • 10% small/medium cap
  • 15% financials
    • 7.5% life insurance/depository banks/investment services
    • 5% large banks/dividend growth
    • 2.5% BDCs
  • 7.5% healthcare
    • 5% pharmaceutical/medical devices
    • 2.5% healthcare services
  • 5% defensives/consumer staples
  • 5% global infrastructure
  • 5% global energy
  • 5% global materials

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.