A Conservative Portfolio: Asset Allocation Daily

by: SA For FAs


Rob Marstrand makes the case for a conservative portfolio.

Cullen Roche makes the case for a bear market, providing investors with more favorable entry points.

Thought For The Day: Because the sources of uncertainty are unlimited and unceasing, it behooves us to always hedge our investments.

Rotation To Value

"It's been a tough decade for investors who focus on attractively valued stocks with unappreciated recovery potential. Global value stocks have underperformed growth stocks for most of the past decade... But signs of life for value have recently appeared. In the third quarter, value stocks in emerging markets beat growth stocks by 8.8%... Value stocks also outperformed growth stocks in October across regions." (AllianceBernstein)

Value Outperformance

"Even if we look at large cap stocks alone, thus removing the small cap stock effect (Chart 3), there remains a long term relative performance spread in favor of value stocks amounting to 5%. If we examine the three Russell indexes…over the time period from 1996 to 2018, we again see out-performance by value in spite of the great ten-year rally we've been in (Chart 4)." (Kevin Wilson)

Housing Market Peak?

"Potential homebuyers now face materially higher interest rates - effective mortgage rates on a standard 30-year mortgage have risen above 5%, and are up by around 100bps in 2018, roughly half of which is due to the rise in long-term Treasury yields and the other half to a higher spread between Treasury yields and mortgage rates. Also, tax changes have reduced the incentives for homeownership and increased the cost considerably for some (those owning or buying high-value homes in states with high property taxes)." (ING Economic and Financial Analysis)

Begging For A Bear Market

"The stock market is an instrument that pays about 7-8% per year in nominal terms and can't mathematically pay out much more than that over the very long term. That is, after all, approximately the rate of corporate profits. So, when you go through these long periods of multiple expansion and 10%+ returns, you have to wonder - "When is Mr. Market going to give back some of that excess return?" Said differently, a little smoothing in stock market returns in the coming years isn't really a bad thing." (Cullen Roche)

Year Of The Dollar

"Looking at some of the major currency pairs against the dollar, the euro is down 5%, the British pound is down 4%, the Chinese renminbi yuan is down 6% and the Japanese yen is more or less flat. So far at least, 2018 has been the year of the dollar. With hindsight, most investors will have found it hard to beat dollar bank deposits. Note: This is not the same as saying investors should have entered the year holding nothing but cash. Things could have turned out very differently for each asset class (better or worse). But it does justify a conservative portfolio allocation, in the face of significant, multiple uncertainties (economic, political, financial), and after many years of emergency monetary policy (ultra-low rates and quantitative easing)." (Rob Marstrand)

Thought For The Day

Take a good look at the quote above from Rob Marstrand. In that brief excerpt, he says four things. 1) He notes that 2018 has been a good year for the dollar. 2) But he cautions that "this is not the same as saying investors should have entered the year holding nothing but cash." 3) That is because things could have turned out differently. And 4) a preference for cash was justified by "multiple uncertainties."

Apologies for more or less repeating with slight alteration what he wrote. It's actually a great credit to him that he deploys his words well and doesn't just bloviate like much of the financial commentariat. But I wanted to distill his points in order to subtly alter one of its assumptions in order to make them even more useful (without assuming that he would agree). That assumption is that what he calls "a conservative portfolio" is justified today, but in a different time period, we'd need to consider a non-conservative portfolio.

Wall Street would certainly agree with that idea; its portfolio gurus offer a flavor of the day. If this were a year of steady positive returns, if there were no elections, and if Fed policy were constant, many would say that risk is on and it's time to grab shares with both fists. But I think this would be shortsighted. In the decades that I have observed financial markets, I can tell you that one thing that has never changed in good times, bad times, and flat markets alike is "uncertainty."

Don't believe me? For the fun of it, google that term, or my favorite variant of it, "growing uncertainty" each day for the next week or so. Try it again in a month, in a year, in a decade. I'm telling you: It never goes away. We don't need midterm elections or Federal Reserve rate hikes as a trigger. If these were not current issues, we might be reading about oil prices, currency wars, or territorial wars. There are political campaigns and military campaigns, inflation and deflation, even stagflation. The sources of uncertainty are unlimited and, importantly, unceasing.

I also quote above an article from Cullen Roche, in which he argues that investors should want to get on with the next bear market already in order to get back to higher expected future returns. His point is that bear markets afford higher long-term returns because of their more favorable entry points. But I make another astute point, which is that most of us really aren't all that long-term in our investing. I quote:

We need to think more long term, but our liabilities are mostly short term. The key is finding that right balance where you can maintain a strategy that is intelligently long term, but not irrationally long term."

And that balance is found in a balanced, or conservative, portfolio. That is to say one that complements stocks with sizeable portions of cash and other countercyclical assets. Many of us are familiar with the long-term returns of U.S., or global equities, and we hold a stocks-for-the-long-run ideal in our minds as some sort of sacrosanct guide to asset allocation. But if this bull market, which has - let's face it - transpired during a mostly mediocre economy - has already logged a record-beating decade, then it doesn't require a lot of imagination to picture a record-beating bear market that crashes into those short-term liabilities that Cullen Roche noted.

For that reason, were 2018 the year of U.S. stocks, we'd still be justified in holding some version of that conservative portfolio Rob Marstrand recommends. Because no matter what, we'd still be facing "growing uncertainty."


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