How To Invest In This Bull Market

by: Alan Brochstein, CFA

This past week marked my 5th anniversary as a Seeking Alpha Contributor. As I reflect on the 454 articles that I have shared, I realize that there may be a void. Most of my articles have been focused on individual stocks, though I often discuss my macro outlook. What I realize is that very rarely have I shared my views on overall portfolio construction, though this is certainly one of my strengths. In fact, I will soon be celebrating my 4th anniversary as a provider of model portfolios to individual investors through Invest By Model.

During the time I have shared my views here, I have been very bearish (in 2007 and 2008, though not bearish enough) as well as quite bullish (since late 2009). While the market may be a little overbought now, and my views are really longer-term, I believe that we are at a key inflection point. We began a bull market in 2009, but it has faced skepticism along the way. In fact, while the previous bull market from 2003-2007 never saw a single 10% pullback in the S&P 500 (NYSEARCA:SPY), we have now seen two very deep (and painful) corrections over the past three years.

As I shared last week, when I confirmed my expectations for 1600 on the S&P in 2012, the retail investor, who has been pulling money out of stocks and dumping it into bonds for the past five years, may be warming up to the idea of owning stocks. It's not surprising that after two bear markets within a decade, the likes of which we hadn't seen since 1973-1974, that the individual investor has shunned stocks. In the long-run, though, the bargain appeal of stocks and the cash flow they will deliver to investors will prevail, and I think clearing last year's peak could be a driver. Additionally, this year's IPO of Facebook (NASDAQ:FB) could prove to be a big catalyst, helping to change perceptions of younger people who have incorrectly assumed that past performance is a predictor of future returns based on what they have observed over the past dozen years.

If you are in sync with my views, please read on, as I believe that there are several actionable items you can take to reinvigorate your portfolio if you have been less-than-fully committed to investing for the long-term. Before I share specific big-picture portfolio structure for three groups of investors, let me describe some overall themes. Here are the key ideas I would like to discuss:

  • Go Small
  • Go Far
  • Growth is Not a Four-Letter Word (Neither is Value!)
  • Don't Believe the Fed

Make Room for Smaller Companies

I have a confession, and those who have followed my work over the past five years already know this, but I have a bias towards small caps, certainly when it comes to individual stocks but perhaps even as an asset class. With that said, they don't always win. I was pretty cautious a year ago and shared those views publicly. Still, for the long, there are lots of reasons small caps as an asset class deserve a spot in your portfolio. Now is one. As I described in January, when I shared a favorable outlook for small caps this year after taking a year off in 2011, there are several reasons to be bullish on small caps:

  • More Engaged Retail Investor
  • Heightened M&A Potential
  • Domestic Focus
  • Less Focus on Dividends

The Cliffs Notes version: A reversal of mutual fund outflows is very likely, and this favors smaller companies typically, which are impacted more by retail investors. In a constrained economic growth environment, M&A is likely to help smaller companies, both because they could get gobbled up but also because they can consolidate small private companies in front of tax-law changes. A rallying dollar and global economic concerns suggests a tilt towards domestic orientation.

Please note that this is likely just a short-term issue, and I am not even sure I am on board with this view. Still, if the dollar continues to strengthen, this should help more domestically focused smaller companies. Finally, the taxes for dividends are likely to rise. Investors have been overcompensating to some degree in their equity selection with a focus on dividend income. I hope my case is clear - refer back to the article for a more in-depth presentation with some nice graphics too!

Go Far

Now, the careful reader will quickly wonder why I am suggesting investing abroad after I just talked about the dollar rising. First of all, when you have a portfolio, it's important to diversify. While the dollar is rising now, that could change later this year. Second, currency is only one aspect to investing abroad. The reason I am suggesting looking into Emerging Markets is simple: Growth (more on growth later). The long-term bullish story revolves around the growth of the middle class in countries like Brazil, Russia, India, China, Indonesia and others. It's possible to participate in a diluted way by investing in Multinationals, but the stocks in these emerging economies are much cheaper. It's difficult to get precise data, but he MSCI Emerging Markets index has a forward P/E below 11X. Many of these economies are more fiscally sound than Japan, the U.S. and Europe as well.

Australia and Canada are interesting non-Emerging Markets options. For the really bold, Europe is recovering quickly but has still lagged the U.S. stock market over the past year. EM is an area where I like the idea of using an ETF or a mutual fund - just a personal preference.

The world is much more connected than ever - I don't buy into the concept of diversification the way it is taught in the business schools. Still, there are scenarios where investing in foreign stocks could provide some diversification as well as protection from a weakening dollar should that play out. I am viewing this as "Alpha", though.

Look for Growth

While in many ways I tend to be more of a value investor than growth (and am reticent to buy at > 20 P/E), I believe that both styles have their role in any stock selection process. In 2009, it was a value-market - babies could be rescued from the bath water without trying too hard. That's how I had a return of almost 69% in my Top 20 Model Portfolio. While I see a lot of value these days, it tends to be less stock-specific than just the overall market.

My view is that there are always stupidly priced growth stocks, and I understand how in the long-run investors who chase them pay the price when they ultimately fail to meet aggressive assumptions, but I am finding many examples of companies that might have used to trade at 25 P/E but now trade at 18 P/E. Perhaps I will follow up with an article where I "name names", but let me walk you through some math. A stock trading at 18X 2012 estimates that is expected to grow 15% this year and then 15% next year will appreciate by 60% (18 * $1 in 2012 is $18, 25*$1.15 in 2013 is $28.75, 28.75/18 is 60%).

The overall cautious tone among investors has constrained what they are willing to pay for stocks. More optimism will result in valuation multiples rising generally, but it will particularly favor higher growth companies in my view. It's like a casino with an empty craps table vs. one where you have to squeeze in. My suggestion here is to look for companies that grew threw the tough times - my guess is that could really grow earnings with slightly better economic conditions. OK - I'll name a name or two: Google (NASDAQ:GOOG), which is huge, or little company like Super Micro (NASDAQ:SMCI) that you probably have never evaluated. Both of these happen to be in my Top 20 Model Portfolio - SMCI for six months and GOOG since after their recent earnings report.

Don't get me wrong - I am still hunting out value situations. Still, at the margin, I am making a very big effort to shift towards growth.

The Federal Reserve: Omnipotent, Perhaps, but Not Omniscient

A Wall Street adage that really has proven to work is the concept of "Don't Fight the Fed". There are many who believe this whole rally is fake - just engineering by the Central Bankers around the world to prop us up, with the ultimate end-game a tragedy that will likely exceed the 2008-2009 experience. Keep fighting, permabears. I know, the low P/Es aren't that low - margins will be plunging, etc. Never mind that there is a lot of slack in the system, but the peak profit-margin school doesn't seem to understand the longer-term secular improvement due to productivity. While there is a risk that global central bankers stay too easy too long, there aren't signs of this so far. Where is the inflation? Certainly not in wages.

Clearly, bond investors haven't been fighting Bernanke - they bit the hook, line and sinker on policy statements declaring low rates will persist ad infinitum (not really but much longer than most people's investment time-frames).

I think it's dangerous to get sucked into expecting rates to stay low, and the "bond vigilantes" will return, enforcing pain on those who think 2% is a good deal for a ten-year investment.

My advice (for a long time) has been to look for income from equities. Whether it's high-quality dividend stories, REITs, MLPs, Utilities or more esoteric things like BDCs (I have written extensively on all of these except MLPs), stable dividends at a cheap price or reasonable dividends that can grow will beat bonds when the environment changes.

I have recently, perhaps accidentally, moved a substantial portion of my Sector Selector ETF Model Portfolio into stocks that I think could perform especially well in the event the Fed keeps pouring the "juice" into the punch bowl for too long: Energy and Precious Metals. In fact, in the last few weeks, I have moved from zero exposure to almost 20%. While my call is really more of a valuation call, I do believe that concerns over inflation could fuel stocks related to these sectors. It's an ETF model, so I went with the SPDR Energy (NYSEARCA:XLF) for Energy exposure, but I went with the Market Vectors Gold Miners (NYSEARCA:GDX) for exposure to precious metals (over the SPDR Gold Trust (NYSEARCA:GLD)). Except for in the most extreme bullish cases for gold, I would expect GDX, which is really cheap in my view (looking at the underlying names), to beat the price of gold, but GLD could also do the trick.

If you have to own bonds (like I do in my Conservative Growth/Balanced Model Portfolio), shorten your maturities and shift to higher-yielding assets. It's alright to own little or no Treasuries - let the Chinese and the pension funds own them.

Applying the Themes


I almost wrote a separate article for the young investor, who I define as 13 (when I started investing) to 30. In my many dialogues with members of the Seeking Alpha community or when I listen to Mad Money, I can't help but feel like even those who are investing are playing it way too safe, focusing on income. Of course, the bigger issue is that younger investors are likely not even in the game.

For the younger investor, I would be allocated 100% stocks and nothing to bonds. Given the themes I shared, I would allocate roughly as follows:

  • 25-35% Large-Cap Core
  • 15-25% International Equity(primarily Emerging Markets, but not exclusively - Emerging Markets ETFs include Vanguard Emerging Markets (NYSEARCA:VWO) or iShares MSCI EM (NYSEARCA:EEM), and there are ETFs for Australia, Canada or Europe too)
  • 50% Small-Cap (35% iShares Russell 2000 (NYSEARCA:IWM) and 15% iShares Russell 2000 Growth (NYSEARCA:IWO) or mutual funds or stocks)

I don't address the inflation issue - a young person has increasing income opportunities, unlike an older investor with much lower earnings potential relative to assets. To me, this is a pretty standard allocation, with a slight bias towards international. The point is that younger investors should not be huddling into overly conservative investments.


I believe that the retiree or those close to retiring are the ones who really need to shake things up. Traditionally, he or she would hold a lot of bonds - they are less risky than stocks, right? I believe that the artificially low interest rates make longer-maturity bonds riskier than typical. Still, income needs to be generated. Also, inflation is a particularly high risk for older investors, who can see their nest eggs depreciate in real terms. So, here are my thoughts for those 60 and older:

  • 40% Large-Cap Core
  • 12% International Equity (VWO for half, and iShares Australia (NYSEARCA:EWA) or iShares Canada (NYSEARCA:EWC) for half)
  • 5% Gold Miners
  • 10% Small-Cap Growth
  • 5% REITs (iShares Dow Jones RE (NYSEARCA:IYR))
  • 5% Utililities (SPDR Utilities (NYSEARCA:XLU))
  • 3% BDCs (you will need to pick one or two - I would recommend Hercules Technology Growth Capital (NYSE:HTGC), Fifth Street Finance (NASDAQ:FSC), Triangle Capital (NYSE:TCAP) or Solar Capital (NASDAQ:SLRC)
  • 10% iShares Barclays MBS (NYSEARCA:MBB)
  • 10% cash or very short-term corporate bond fund

This portfolio gets the yield from various sources, takes minimal interest-rate risk and has several potential inflation hedges. The overall equity exposure is 80%, but much of it is oriented towards income. I omitted MLPs, which seem somewhat expensive at this time, but they certainly might be included as well. Obviously, "60 and older" isn't a homogenous group - the allocation would likely vary depending on factors like age, whether the investor works or not an many other factors. It's just a guideline!


For those between 30 and 60, who I am viewing as more tolerant of risk, I would allocate a bare minimum to bonds. This is a time to be more aggressive than typical. Here is how I would position the equity portion of the portfolio:

  • 48% Large-Cap
  • 28% Small-Cap
  • 18% Emerging Markets
  • 6% Gold Miners

Where did I come up with these numbers? It's actually the way I have my Sector Selector ETF Model positioned currently. If you want to see the exact weightings of the 9 ETFs I am using in that model, you can take a peek with a free-trial. I launched this model at a horrible time - the peak of the market last April. After the rough start, the model has moved slightly ahead of the S&P 500.

The largest Large-Cap is SPDR Financials , followed by Energy (NYSEARCA:XLE), Technology (NYSEARCA:XLK) and Industrials (NYSEARCA:XLI). ETFs or index funds are the way to play Large-Cap, and you can simplify by just going with SPY.

For Small-Cap, I actually prefer individual stocks or mutual funds, but the ETFs I use include IWM as well as a sector ETF and a Micro-Cap ETF. As I write this, I realize that I have failed to skew the model towards growth. Since the year began, IWO has only slightly outperformed IWM, so I haven't missed much yet.

I do have the growth play in the Emerging Markets, where I use VWO. As I mentioned, I added GDX very recently - last week, in fact.

So, I hope that I have shared my ideas in a way that compels the reader to think about his or her own investments. If you agree with me that better times lie ahead, it's time to restructure portfolios. The examples I share are simply examples, but hopefully they point you in the right direction in terms of building your own portfolios. Let me know your thoughts.

Disclosure: Many of the ETFs mentioned are owned in model portfolios at Invest By Model. SMCI and GOOG are owned in the Top 20 Model Portfolio at Invest By Model.