Can Quarterly Asset Allocations Predict Future Stock Performance? If So, What Action Should Many Investors Take Now?

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Includes: VOO
by: Tom Madell
Summary

Most investors try to formulate appropriate allocations to stocks vs. bonds and cash.

But do these allocations predict future returns? And if so, how far ahead?

Ten years of quarterly allocation data were analyzed.

High allocations to stocks were associated with significantly higher returns over the following three years and vice versa.

Since research based allocation judgments currently suggest lower stock allocations, to avoid low returns, investors may want to have a lower than normal allocation now.

Most investors try to formulate appropriate allocations to stocks vs. bonds and cash, even if the latter are close to zero. Some try to keep that allocation fixed, such as for example, 60%/40%, stocks to bonds. Others, however, might regularly alter the mix depending on a variety of factors, such as for example, rising vs. falling interest rates, strength of economic growth, etc.

The question to be addressed in this article is, assuming the use of a changing quarterly asset allocation, coupled with a relatively long-term approach to determining these allocations, is it possible to enhance a portfolio's returns by assuming that relatively high allocations to stocks suggest better returns several years down the road?

Of course, high allocations should mean an expectation of better stock market returns ahead, and vice versa, otherwise, why would you invest a high percentage in stocks at all. But I would assume that most investors who make changes to their allocations as frequently as once every quarter or so, would not really expect these changes to be predictive of overall stock returns for periods as great as three years. So if they were predictive, investors could have some degree of confidence that their long-term future portfolio performance would likely be more successful when current allocations were high, and vice versa.

For many years now (actually going back to 2000), I have been making such quarterly allocations as part of a set of Model Portfolios that I publish on my website. One of my main interests, then, has been addressing if these changing allocations prove to correspond to reality. More specifically, suppose I tell my readers who have a moderate risk profile that 65% of their investments should be in stocks and say 30% in bonds, and 5% in cash, will those who follow that suggestion be rewarded with higher subsequent returns than those who chose to invest only 50% in stocks?

Of course, choosing a relatively low allocation to stocks may not just be about achieving the highest returns. One might stick with a lower allocation in order to reduce their level of risk. But assuming that most "moderate risk" level investors truly want to achieve the highest level of returns while keeping their risk level moderate, a recommendation for a higher level of stock allocation should be interpreted as a favorable sign that assumes the same level of risk as before the recommendation.

As is typical, the stock market has exhibited highly variable returns over the last decade with many events occurring that could have potentially influenced relatively short-term results. But if one is a long-term investor, one can see that it should pay to try to overlook events that might only influence one's returns relatively briefly and focus instead on possible long-term influences. With this in mind, let's look at my quarterly allocations to stocks beginning in Jan. 2005 and compare them to subsequent three year annualized returns for the S&P 500 index.

To better visualize the effect of a high vs. a lower level of allocation to stocks, we present the results in two tables. The first table shows all quarters going back to 1-05 in which we, on the date shown, recommended a relatively high allocation to stocks. This was arbitrarily defined as 55% or higher for Moderate Risk Investors. The second table shows all quarters since 2005 in which we, on the date shown, recommended a relatively low allocation to stocks, which we defined as 52.5% or below.

Here are the results, followed by further analysis. Note that since we chose 3 years after an allocation was made to analyze results, the latest quarter to be included was 1-12; for 4-12 and beyond, 3 years has not elapsed yet.

Table 1: Annualized Returns for the S&P 500 Index
3 Yrs. After "High" Stock Allocation Recommendations
Quarter Beginning Allocation
to Stocks
Annualized
Return
Quarter Beginning Allocation
to Stocks
Annualized
Return
1-12 62.5% 20.4% 4-10 60 12.7
10-11 60 23.0 1-10 57.5 10.9
7-11 62.5 16.6 10-07 55 -7.2
4-11 65 14.7 7-07 55 -9.8
1-11 65 16.2 4-05 55 5.8
10-10 62.5 16.3 1-05 55 8.6
7-10 60 18.5

Note: The average yearly return for these high allocation recommendations was 11.3%

As can be seen, three years after relatively high allocation recommendations were made, most of the annualized returns on the S&P 500 index turned out to be excellent, ranging from over 20% to a little less than 9% per year. These recommended allocations, therefore, were highly successful in suggesting good future performance.

In numerical terms. the success rate of the high allocation recommendations in Table 1 was 77%. or 10 out of 13 comparisons.

Table 2: Annualized Returns for the S&P 500 Index
3 Yrs. After "Low" Stock Allocation Recommendations
Quarter Beginning Allocation
to Stocks
Annualized
Return
Quarter Beginning Allocation
to Stocks
Annualized
Return
10-09 50 13.2 4-07 52.5 -4.2
7-09 50 16.5 1-07 52.5 -5.6
4-09 45 23.4 10-06 52.5 -5.4
1-09 37.5 14.2 7-06 50 -8.2
10-08 42.5 1.2 4-06 52.5 -13.0
7-08 45 3.3 1-06 52.5 -8.4
4-08 47.5 2.4 10-05 52.5 0.2
1-08 52.5 -2.9 7-05 52.5 4.4

Note: The average yearly return for these low allocation recommendations was 1.9%

In this table, you can see that three years after relatively low allocation recommendations were made, the majority of the annualized returns on the S&P 500 index turned out to be poor, ranging from -13% to a meager +3.3% per year.

In some quarters, a low stock allocation did not produce a low three year annualized return. In fact, these quarters subsequent performance showed just the opposite, a high 3 year annualized return.

In numerical terms, the success rate of the low allocation recommendations in Table 2 was 75%, or 12 out of 16 comparisons.

When I applied the same kind of analysis on my high vs. low allocation to bonds, I got the same kind of results favoring the high allocations to the lower ones by a significant amount. (These results are reported at this link.)

Further Analysis of These Results

These observations will help to put this data in perspective:

-We recommended relatively high allocations to stocks early in 2005, in the latter half of 2007, and in the years following the end of the 2007-2009 bear market. Of course, as we began raising our allocations considerably beginning in 2010, no one could know that a continued multi-year bull market lay ahead. But the factors that we regarded as important suggested higher allocations would enhance returns.

-We recommended relatively low allocations to stocks in the years leading up to the 2007 bear market and for its duration. As above, no one knew in those years that a bear market was coming and when it came, when it would end.

-The average degree of difference between the subsequent returns of our higher and lower allocation quarters was substantial - nearly a 9.5% better annualized return in favor of the former (11.3 vs. 1.9%).

-However, we tended to make the wrong allocation judgment ahead of "turning points": When the market was about to go from bull to bear (2007), we were too positive; when it was about to go back into bull mode (early 2009) and a little beyond, we were too negative.

-Absolute percent level of allocation to stocks was not the key; what was key was a relatively high allocation vs. a relatively low allocation, as defined above. In other words, when we had a strong sense that stocks would do well, as compared to at other times, they usually did; when we had a weak sense that stocks would do well, as compared to at other times, they usually didn't.

What This Data Suggests for Future Returns

Of course, in investing, past data can never ensure or guarantee that future results will be similar.

But what I have demonstrated above is that you should not assume that pre-selecting a fixed asset allocation that seems appropriate for your risk tolerance and keeping your allocations at or near this allocation is a rock solid, guiding principle for managing your investments. Yet such a prescription typically appears to form the basis of how very many investors indeed manage their investments from year to year.

A cursory look at the above tables shows the obvious - that investment returns, particularly for stocks, vary greatly from quarter to quarter and from year to year. Most of us have been told, though, by investment experts that it is extremely hard, if not impossible, to accurately forecast in advance what these changes will be.

But the above tables seem to demonstrate that even two or three years in advance, it is possible to use well-chosen information to get a good sense of what kinds of returns, generally at or above par, or below par, might be expected from stocks and bonds. The problem most people run into, at least in my opinion, is that they mainly focus on trying to predict how stocks or bonds will do for much shorter periods. It is mainly such predictions that have a much reduced chance of success.

Unfortunately, as you might have anticipated, I can't provide an all-in-one formula for attempting to make accurate predictions for two or three years down the road. But let me just reiterate that it is possible to successfully make such predictions, especially if one gives up on a) looking too much at short-term events that likely won't matter much in a year or two and focusing instead of matters that likely will matter; and b) expecting the predictions to always be right; if you are unwilling to proceed without near 100% certainly, you will miss out on many likely outcomes that will happen the majority of the time, but not 100% of the time.

In our most recent Model Portfolios, I have dropped back our allocations to both stocks and bonds, but especially stocks, from where they were several years ago. Take a look at the most recent allocations for moderate risk investors:

Recent Overall Quarterly Asset Allocations
for Stocks and Bonds
Quarter Beginning Allocation
to Stocks
Allocation
to Bonds
Quarter Beginning Allocation
to Stocks
Allocation
to Bonds
4-12 67.5 25 10-13 55 25
7-12 67.5 27.5 1-14 52.5 25
10-12 67.5 27.5 4-14 50 27.5
1-13 67.5 27.5 7-14 50 25
4-13 67.5 27.5 10-14 50 25
7-13 65 25 1-15 50 25

These stock allocations suggest that if the predictive patterns of our earlier allocations hold true, upcoming 3 year returns for stocks may soon start to fall back considerably for periods beginning 1-14. And if the results turn out matching pretty closely those reported in Table 2, it is possible that within the next few years, stock returns between 2014 and 2017 may wind up averaging in the low single digits when annualized over three years. This means that since 2014 was a pretty good year for stocks, especially the S&P 500, either 2015 and 2016 or both, will likely show considerably smaller, or even a year (or possibly two) of negative, returns.

Two year average returns for bonds have already dropped off considerably since early 2011, and our recent below average allocations suggest that the same will likely continue for the next few years.

How should moderate risk investors position their investment portfolios over the next several years? In light of the above findings, it is suggested that investors who want to avoid potentially subpar returns from the main stock benchmarks, mirrored by investments such as Vanguard 500 Index ETF (NYSEARCA:VOO), should consider deviating away from the relatively high allocations that have been successful since the start of the 2009 stock bull market. Such returns, according to data suggested by this research, could be coming for stocks for at least the next several years.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.