Trim U.S. Equity Exposure As Cyclical Stocks Get Extended


Model portfolio exposure to U.S. cyclical and EM equity has been reduced.

Foreign developed equity and non-cyclical equity holdings have been increased.

Fixed income holdings have been shifted slightly toward riskier assets at the short end of the yield curve.

We have reduced U.S. equity exposure in most of our model portfolios following another strong month of U.S. large-cap stock price performance, particularly among cyclical sectors. The projected equity premia for U.S. large-cap cyclical equity vs. TIPS is the lowest in over a year. And investors now receive only ~30bp of additional expected return for investing in cyclical U.S. equity vs. non-cyclical U.S. equity, the lowest such premium since early 2014.

A jump in emerging market equity prices has resulted in lower exposure to this asset class across most of our model portfolios. Exposure to foreign developed equity is higher m/m as a weaker dollar continues to boost the value of foreign earnings.

Our optimal portfolio for an investor with average risk tolerance includes a 56% allocation to equity, down 3 points m/m. U.S. large-cap equity exposure is down ~2 points and emerging markets equity holdings are down ~4 points, while foreign developed equity holdings are up ~3 points m/m.

Note that some of the shift in the optimal model portfolios this month is impacted by liquidation of the international sector SPDRs, resulting in a shift to the iShares global sector ETFs as the best vehicle to achieve optimal exposure to non-cyclical equity.

Lower equity holdings across model portfolios have led to a higher allocation of short-term fixed income securities. In addition, optimal holdings of intermediate and long-term fixed income have increased for investors with higher levels of risk tolerance. TIPS exposure edged lower where it was previously included, as risky fixed income assets are slightly more attractive vs. a month ago at the shorter end of the yield curve.

We estimate the optimal portfolio for an investor with average risk tolerance to have an annual standard deviation of 7.9%, in line with the backtested median since the end of 2006.

The projected long-run annual return of our optimal model portfolio for an investor with average risk tolerance is 3.2% after inflation, down 20 bp m/m. The backtested median projected return of this portfolio is 3.5% since the end of 2006.

Optimal Long-term Asset Allocation for Investor with Average Risk Tolerance


Long-Term Equity Market Return Outlook:

Projected Long-Run Annual Real Returns


The projected U.S. large-cap equity return is slightly lower for cyclical sectors following a 2% return for the S&P 500 in July. The strong performance among cyclical U.S. equity was broad-based, led by a 4% gain for technology stocks. The projected return for non-cyclical U.S. equity is unchanged, given muted July stock price performance among consumer staples and healthcare shares.

Our forecast for U.S. large-cap equity returns implies average annual mid-cycle earnings of $121 for the S&P 500 index companies, up $1 from the prior month. This earnings outlook compares to the consensus bottoms-up forecast of $138 over the next four quarters for S&P 500 earnings.

The gap between the projected returns of cyclical and non-cyclical U.S. large cap equity is now just 30 bp. This is the first time since early 2014 (in the wake of a sharp surge in U.S. stock prices) that the premium return offered by more economically sensitive large-cap U.S. equity has been less than 40 bp.

Difference Between Projected Cyclical and Non-cyclical Equity Returns


The projected return largely is unchanged m/m for U.S. small and mid-cap equity as smaller cap stocks lagged large caps in July. We still project a higher return for large-cap U.S. equity, limiting the role of smaller cap stocks in our model portfolios.

The projected return for foreign developed large-cap cyclical equity is little changed m/m despite a 3% gain for the MSCI EAFE Index in July. For the 4th consecutive month, a stronger euro has increased the dollar value of projected earnings.

The estimated 130-bp premium offered by foreign-developed cyclical equity over U.S. cyclical equity is above the average of 85 bp over the past five years. As a result, our model portfolios continue to favor foreign developed over U.S. cyclical equity.

The return outlook for emerging markets large-cap cyclical equity is sharply lower m/m following a 6% gain for the MSCI Emerging Markets Index in July. The 180-bp return premium offered by emerging markets over U.S. equity is in line with the three-year average of 170 bp; however, the 50-bp return premium over foreign-developed cyclical equity is now below the three-year average of 80 bp. As a result, exposure to emerging markets equity has been reduced in most model portfolios.

Cyclical Large-Cap Equity Premia


Long-Term Fixed Income Market Return Outlook:

Projected Long-Run Annual Real Returns


Projected real fixed income returns have increased m/m as the forward U.S. TIP curve has moved higher across maturities. In addition, inflation risk premia have perked up a bit, mitigated by a modest decline in credit risk premia as credit spreads have trended lower.

The estimated real term premium offered for 10-year U.S. Treasury (UST) bonds has decreased 3 bp m/m. A 10-year UST note purchased in five years offers 30 bp of additional return over a 52-week UST bill. This level is below the 10-year average real term premium of 57 bp.

Risk-Free Real Term Premium


The inflation risk premium has jumped 10 bp m/m to 14 bp for a 15-year bond. Still, this inflation premium remains below 20 bp for the 22nd consecutive month as bond markets continue to imply a significant possibility of disinflation.

Inflation Term Premium (15-Yr. Bond)


We estimate that investors in investment grade corporate bonds are receiving ~7 bp of return for every year to maturity as compensation for credit risk, down 1 bp from a month ago. The current credit risk premium is above the 5-year average of 5 bp for every year to maturity.

Credit Risk Premium Per Year


The Model Portfolio for an Investor with Average Risk Tolerance:

We have reduced equity exposure to 56% from 59% in the prior month. Broad U.S. large-cap equity is down 3 points m/m, and exposure to emerging markets equity has been reduced by 5 points, while broad foreign developed equity holdings are 2 points higher m/m and global consumer staples exposure is 3 points higher m/m. We continue to recommend Schwab U.S. Large-Cap ETF (SCHX) with its 3-bp expense ratio for broad-based U.S. equity exposure, iShares Core MSCI Emerging Markets ETF (IEMG) and its 14-bp expense ratio for broad-based emerging markets equity, and iShares Core MSCI EAFE ETF (IEFA) and its 8-bp expense ratio for broad-based foreign developed equity.

We have changed our sector ETF holdings following the liquidation of the SPDR international sector ETFs in late July. Since there is no adequate substitute for these international sector funds, we recommend that investors also sell their holdings in the Fidelity U.S. sector funds and instead utilize the iShares global sector ETFs to best achieve an optimal allocation to non-cyclical equity. In particular, the model portfolio below includes allocations to the iShares Global Consumer Staples ETF (KXI), the iShares Global Consumer Healthcare ETF (IXJ), the iShares Global Telecom ETF (IXP), and the iShares Global Utilities ETF (JXI). These are the most expensive ETFs in the portfolio (by far) with an expense ratio of 48 bp, but their inclusion boosts the expected utility of the portfolio even after these fees are taken into account.

Short-term bond holdings are up 3 points m/m while TIPS holdings have been reduced by 1 point, as risky fixed income assets are slightly more attractive vs. a month ago at the shorter end of the yield curve. Preferred short-term bond holdings include Vanguard Short-Term Government Bond Index ETF (VGSH) and Vanguard Short-Term Corporate Bond Index ETF (VCSH), both with an expense ratio of just 7 bp.

We caution that these recommendations may not be optimal for investors that make frequent changes to their portfolios as sector ETFs tend to have higher bid-ask spreads than the most liquid broad-based ETFs.


Methodology, Definitions of Terms and Other Disclosures:

Our portfolio recommendations are designed for investors with longer-term horizons only (greater than 5 years). Our systematic approach to portfolio construction relies upon detailed analysis of the fundamentals that impact equity and fixed income asset class returns and risks.

ArcPoint combines algorithms with human expertise to analyze several thousand public companies and determine the likely average earnings each company will achieve over an economic cycle. Companies are then grouped into twelve equity asset classes with distinct primary regions, market capitalizations, and degrees of sensitivity to economic cycles. This aggregation of hundreds of individual company forecasts unlocks the ability to forecast real long-run returns for specific equity asset classes.

The “cyclical equity” asset classes refer to companies in the consumer discretionary, energy, financial, industrial, information technology and materials sectors. Companies in the consumer staples, healthcare, telecommunications, and utilities sectors are included in the “non-cyclical equity” asset classes. We utilize the sector definitions of Standard & Poor’s to classify companies as necessary.

“Large cap equity” asset classes include companies with market capitalizations greater than $6.5 billion. All other companies are included in the “small/mid cap equity” asset classes.

We derive expected return projections for eight fixed income asset classes with an analysis of the long-term expectations embedded in publicly traded bonds, including expected real rates of return across the term structure, as well as compensation for inflation and credit risk.

“Short-term fixed income” includes bonds with maturities of 1-4 years, “intermediate fixed income” includes bonds with maturities of 4-10 years, and “long-term fixed income” includes bonds with maturities longer than 10-years.

Risk and correlation projections for each asset class are calibrated with an understanding that return correlations spike during periods of market turmoil. As a result, ArcPoint will tilt recommendation weightings toward asset classes with lower risk - appropriate for investors that care first and foremost about preservation of capital.

Any references to “model portfolio performance” refer to theoretical time-weighted gross returns and do not represent actual investment results. Actual results may significantly differ from the theoretical returns presented. Adjustments to our model may result in performance figures that differ from those reported in prior publications. Performance since inception refers to the period beginning 12/31/13 through the month ended prior to the publication of this report.

Disclosure: I am/we are long SCHX, IEFA, IEMG, KXI IXJ, IXP, JXI, VGSH, VCSH, LTPZ, AGG, VGIT, VGLT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.