U.S. Stocks Are Chanting 'Defense, Defense'

by: Reason Investments

Our forecast return for defensive U.S. large-cap stocks is nearly at parity with our forecast for cyclical U.S. large-cap equity for the first time since early 2014.

The projected equity premia for large-cap cyclical equity vs. TIPS is lower across all major regions, leading to lower allocations for U.S. and foreign developed cyclical stocks in most portfolios.

Short-term bond allocations are slightly higher across most model portfolios.

The chant of “defense, defense” grows louder, at least for the U.S. stock market. Our forecast return for defensive U.S. large-cap stocks, or what we call non-cyclical U.S. large-cap equity, is nearly at parity with our forecast for cyclical U.S. large-cap equity for the first time since early 2014. We estimate that a long-term investor will earn just under 5% annually after inflation with a basket that includes stocks in the consumer discretionary, energy, financials, industrials, IT, materials, and real estate sectors. But the same return can be earned with a basket comprised of stocks in the consumer staples, healthcare, telecom, and utilities sectors. The difference is that the latter basket has roughly a third less downside risk!

The near parity of U.S. cyclical and non-cyclical return projections results in higher allocations of non-cyclical equity across a majority of our model portfolios. And we have slightly reduced overall equity exposure in our model portfolios following an m/m increase in bond yields coupled with higher equity prices in the U.S. and foreign developed markets.

The projected equity premia for large-cap cyclical equity vs. TIPS is lower across all major regions, leading to lower allocations for U.S. and foreign developed cyclical stocks in most portfolios. For some model portfolios, the allocation to emerging markets actually is slightly higher as the m/m reduction in the projected risk premium for this sector is smaller than for developed market risk premia.

Bond allocations are slightly higher across most model portfolios. Short-term bond holdings have increased as the front end of the forward UST yield curve had a sharper upward move in September. And an improvement in the credit risk premium has led to a shift toward funds with greater corporate bond exposure.

Our optimal portfolio for an investor with average risk tolerance includes a 57% allocation to equity, down 2 percentage points m/m. Non-cyclical equity exposure is up 1 point m/m, while cyclical equity exposure is down 3 points m/m. Short-term bond holdings are have been increased by 2 points.

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

Source: arcpointadvisor.com

Long-Term Equity Market Return Outlook:

Projected Long-Run Annual Real Returns

Source: arcpointadvisor.com

Projected U.S. large-cap equity returns are slightly higher for non-cyclical equity and unchanged for cyclical equity following a 2% return for the S&P 500 in September. Prices declined slightly for consumer staples, utilities, and telecom stocks, while healthcare price gains trailed the broader market. Energy, financials, and industrials all had price gains of 5% or better in September, but our forecast for cyclical equity returns was unchanged due to higher forecast earnings.

Our forecast for U.S. large-cap equity returns implies average annual mid-cycle earnings of ~$123 for the S&P 500 index companies, up $3 from the prior estimate. 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 a scant 10 bp. The last time this gap was less than 20 bp was in the wake of a sharp surge in U.S. stock prices in early 2014.

Difference Between Projected Cyclical and Non-cyclical Equity Returns

Source: arcpointadvisor.com

A 6% jump in the Russell 2000 during September, aided by strong gains in financials, results in a lower projected return m/m for U.S. small and mid-cap equity. We have not included small and mid-cap U.S. equity in our model portfolios since October 2016 as large-cap forecast returns have been persistently superior with less expected risk. Note: we do not factor a small-cap return anomaly into our analysis.

The projected return for foreign developed large-cap equity is unchanged m/m as a 2.5% gain in the MSCI EAFE Index for September is coupled with higher forecast earnings. The earnings outlook improved despite the euro weakening against the dollar for the first time in five months.

The estimated 140 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 such, our model portfolios favor foreign developed over U.S. cyclical equity.

The return outlook for emerging markets large-cap cyclical equity is unchanged m/m following a 0.4% decline for the MSCI Emerging Markets Index in September. The 160 bp return premium offered by emerging markets over U.S. equity is in line with the three-year average of 170 bp, however, the 20 bp return premium over foreign-developed cyclical equity is now below the three-year average of 80 bp.

Cyclical Large-Cap Equity Premia

Source: arcpointadvisor.com

Long-Term Fixed Income Market Return Outlook:

Projected Long-Run Annual Real Returns

Source: arcpointadvisor.com

Projected real fixed income returns have moved higher m/m as the forward U.S. TIP curve is higher across maturities, particularly at the short end of the curve. In addition, credit risk premia increased m/m, lifting projected returns for longer maturities.

The estimated real term premium offered for 10-year U.S. Treasury (UST) bonds is 2 bp higher m/m. A 10-year UST note purchased in five years offers 31 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

Source: arcpointadvisor.com

The inflation risk premium is unchanged m/m at 7 bp for a 15-year bond. The inflation premium remains below 20 bp for the 24th consecutive month as bond markets continue to imply a significant possibility of disinflation.

Inflation Term Premium (15-Yr. Bond)

Source: arcpointadvisor.com

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, up 1 bp from a month ago. The current credit risk premium is slightly above the 5-year average of 5 bp for every year to maturity.

Credit Risk Premium Per Year

Source: arcpointadvisor.com

The Model Portfolio for an Investor with Average Risk Tolerance:

We have reduced equity exposure to 57% from 59% in the prior month. Non-cyclical equity holdings are 1 point higher m/m (sector ETF holdings of global consumer staples and global healthcare together are 3 points higher m/m), while cyclical equity exposure has been reduced by 3 points. 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.

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 2 points m/m 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 Government Bond ETF (VGSH) and Vanguard Short Corporate Bond ETF (VCSH), both with an expense ratio of just 7 bp.

Source: arcpointadvisor.com

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 includes 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 the 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, VGIT, AGG, LTPZ. 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.