We are taking advantage of last week’s stock market bounce to increase our portfolio defenses. Thursday’s Fed-induced relief rally does nothing to alter the deterioration we have seen in recent months in both the market and economic backdrop.With the S&P 500 now having retraced approximately 50% of its May/June decline, and trading only 4% below its bull market highs, we think now is an opportune time to make our portfolios more defensive. We view the recent rebound in stocks as a counter-trend rally, rather than the start of a sustained move higher, and the oversold conditions and high levels of short-term market pessimism that produced the recent market strength have likely largely been used up.
The combination of (1) elevated inflation pressures, (2) slowing economic growth (with the possibility of a hard landing in the real estate market and a significant retrenchment in consumer spending), and (3) stiff monetary headwinds from Fed tightening and longer-term interest rates moving to their highest levels in four years presents a poor risk/return environment in the financial markets. Moreover, the weakest seasonal period of the year is ahead in September and October, and we are also facing the most vulnerable stock market phase of the presidential cycle in the months preceding the mid-term elections.
The outlook for an economic slowdown, which is implied by the flat yield curve, is also reflected in the continued deterioration we are seeing in the leading economic indicators. The annual growth rate in the weekly leading economic index of the Economic Cycle Research Institute [ECRI] has now fallen to 1.2%, which is a one-year low. With evidence of a slowdown building, consensus expectations of continued double-digit S&P 500 earnings growth into 2007 appear highly optimistic and vulnerable to disappointment. The latest Fed statement noted the softening in the economic backdrop and contained hints of an end to tightening, but there is real inflation in the system, which is the product of several years of extremely loose monetary policy and credit conditions, and this may prevent the Fed from moving to the sidelines at its next FOMC meeting in six weeks.
Our portfolios are now the most conservative they have been since the start of the bull market. The current rally may well continue into July and take the averages up another few percentage points, but we consider the medium to longer-term risks in the market to be much more significant than the extent of this rally. The weight of the evidence suggests that the downside risk is significantly greater than the upside potential and that the odds are high that the market will be lower in the early part of the 4th quarter than it is today.
AgileInvesting Recommended Portfolios
Conservative Portfolio: Reduce allocation to the iShares MSCI EAFE fund (NYSEARCA:EFA) from 10% to 7%. Increase allocation to cash from 19% to 22%.
Moderate Portfolio: Reduce allocation to the iShares S&P 500 fund (NYSEARCA:IVV) from 20% to 15%. Increase allocation to cash from 12% to 17%.
Aggressive Portfolio: Reduce allocation to the iShares S&P 500 fund (IVV) from 25% to 20% and the iShares MSCI EAFE fund (EFA) from 12% to 10%. Increase allocation to the iShares 1-3 Year Treasury Fund (NYSEARCA:SHY) from 10% to 15% and increase allocation to cash from 12% to 14%.