My Thoughts On The Cycle And Asset Allocation

by: Brian Sanders

The economy could be midcycle, but we're likely in late innings.

U.S. equity valuations appear frothy.

A free lunch is diversification: stocks, IG bonds, gold, and ST treasuries.

Going "all in" on one asset class will destroy capital.

I always talk about or concern myself with what stocks will provide the best risk-adjusted returns over a 5-year or longer period, often seeking a double-digit annualized return.

Nonetheless, asset allocation is equally important. Most investment advisers will tell you that 80/20 (equity and bonds) is standard if you're in a younger age bracket, which is then slowly shifted to 80/20 (bonds and equity) as you approach retirement. Essentially, you swing from growth to income. Some advisers may also push you into other areas such as alternative investments, high-yield bonds, commodities, inflation-protected securities, real estate, structured products, etc.

I try to keep it simple by holding four core classes: individual stocks, investment grade bonds, gold, and cash.

The Cycle

The economic cycle appears to be somewhere in between the middle to late stages. The later stages appear likely given many central bankers are worried about slowing growth. The only way we could be in the "middle stages" is if central banks suppress interest rates for longer and add more liquidity to the financial system. However, this would be a bad outcome because persistently low interest rates create incentive for every government and corporation to borrow more. Some debt is good, excessive debt is bad.

Today, there is record financial leverage in both governments and corporations worldwide. For example, the United States federal debt to GDP is 104% and non-financial corporate debt (NFCD) to GDP is 46%, or 150% on a consolidated basis. For China, federal debt to GDP is about 50% after recent stimulus, and NFCD to GDP is about 160%, or 210% on a consolidated basis. The Eurozone's government debt to GDP is 87% and NFCD to GDP is about 137%, or 224% on a consolidated basis.

Point being, there is more debt in the system than ever before, and borrowing clearly has diminishing returns. For every dollar you put into the system via spend, hopefully, your return will be greater than a dollar. As government debt exceeds 100%, for example, the return on that spend begins to erode quickly. It becomes malinvestment.

So, how is growth? U.S. GDP growth averaged 3.4% over the last three quarters, a huge boost over recent years due to tax reform legislation. But with that policy 'in the rear view mirror', GDP growth is cooling off to ~2%. In the Eurozone, GDP growth is very tepid at 1% and slowing; Italy is already in a recession. Asia is slowing down as well, and China has sharply decelerated from ~7% annual growth to ~6%. Furthermore, industry analysts contend that actual GDP growth is closer to 5% or possibly 4% depending on how pervasive fraudulent accounting activities are.

These are, of course, just the base cases assumed by forecasters for these major economies, barring any unforeseen shocks.


In the U.S. equity market, valuations stand at record highs. The S&P 500 (SPY), for example, has a price-to-sales ratio of 2.1x, the highest in 30 years. For the Russel 2000 (IWM), the forward price-to-earnings ratio is 23 times earnings, the top quartile is about 15 years (see the chart on page 5, figure 7 provided by Yardeni Research here). Also, the proportion of IPOs with negative cash flow versus positive cash flow has reached a decade high.

The commonly cited S&P 500 forward earnings look more reasonable at approximately 17x. So, through that lens, investors believe the market is fairly valued. However, when corporations lose their ability to continually hike prices on their products and services, revenue can slip. In the same vein, when the labor market tightens, wages rise, and operating margins can contract. These are two risks to consider for corporate earnings in the coming years.

For bonds, after the recent rally in junk (SPDR Bloomberg Barclays High Yield Bond ETF (JNK)) (and leveraged loans), they are currently yielding just over 6% using yield-to-worst. However, adding in a gross expense of 40 bps, the annual yield is about 6%. If the default risk is layered in over the investment horizon, the principal, let alone the return, craters. The average rating on the companies within most of these exchange-traded funds is "B," which, after a single letter downgrade, has an immense risk of default over a three-to-four year investment horizon. The average maturity is about six years.

Some Selections

Just because there is some chance equities and bonds will underperform in the coming years relative to historical averages doesn't mean your exposure should be nil. Stocks have outperformed every other asset class since the beginning of capitalism. Plus, some companies will outperform the market and, in certain cases, by a lot.

Pertaining to stocks specifically, Google (NASDAQ:GOOG) (NASDAQ:GOOGL) is one of my favorites. While it has more than doubled in the last 5 years, revenue continues to grow about 20% annually, R&D and capex are at record-highs, funding countless ventures (including YouTube stream, autonomous driving, AI, home services, renewable energy, etc.), margins are still quite high, returns on capital are in the high teens, it's cash rich, and yet its valuation is similar to the broader market. A couple other long-term winners, in my view, are Apple (AAPL) with its sticky customer base, and well-diversified Berkshire Hathaway (BRK.B), which is shifting away from an "investment vehicle" into an "operating business." They are both cash-rich companies and are investing heavily in the future, particularly in their management teams and employees.

For bonds, I think investment grade is a good choice, given effective yields are trending at multi-year highs. Some of the spread versus treasuries has gone away since January. However, high-quality A-rated investment grade iShares Aaa – A Rated Corporate Bond ETF (QLTA) is still a decent option. You receive a 3.1% annual dividend yield and have very limited credit risk. Compare that to a BBB-rated ETF, such as iShares iBoxx $ Investment Grade Corporate Bond (LQD), which offers 3.6% in yield but contains a pool of companies that could be subject to downgrade in a recession by the credit agencies. Effectively, 0.5% is sacrificed for a lot more protection of principal. Gross expense ratios are 0.15% for each.

Regarding "my precious" gold (SPDR Gold Trust ETF (GLD)), many investors sometimes weigh it up to 5% to 10% of their portfolio to serve as a hedge. There haven't been any signs of inflation (what it's traditionally used for as a hedge), but it is often seen as a "risk-off" or safe-haven asset. Many investors flee to precious metals, particularly gold (and silver) in the times of crisis, and this will offset some downside risk with stocks during a recession. Generally, precious metals tend to increase in value over the long term than fall. Gold has been trading range bound for 5 years now. If history is any indicator, now would be a decent time to pick a position. By the way, Bridgewater Associates accumulated a large gold position in 2018, and central banks are also buying gold hand over fist.

Lastly, there's cash and short-term treasuries. Short duration treasuries are pretty much equivalent to cash, and should rates rise off their record low levels, interest rate risk is avoided too. With the 1-3 month T-bill (BIL), it has a modest gross expense ratio of 0.2%. While as liquid as cash, you receive a dividend yield of 1.8% while it's parked there. Maybe you can find something better in a savings account at 2+%, but this isn't too shabby.

Bottom Line

No one has a crystal ball, but I do know that global debt is high, and economic growth is slowing. These two conditions usually portend recessions, which almost always translate into a collapse of stocks, certain bonds, and other asset classes. U.S. equity valuations are quite high and international markets, both developed and emerging, have seen some serious volatility in the past year. Investors should keep a level-head, though.

Holding 100% stock is suicidal as you could potentially lose a significant amount of your portfolio via multiple contraction, dividend cuts, bankruptcies, etc. and could stand to wait many years before your investments recover. Holding 100% bonds doesn't work because long-term returns will be significantly lower versus stocks, given central banks have suppressed rates. Holding 100% cash isn't a good decision either because that subjects your wealth to inflation, which probably clocks at 2% on the low end and 5% on the high end. Image a downturn doesn't occur for another 5+ years? You could stand to lose a quarter of your purchasing power over that period.

At the end of the day, investors need to hold a mixture of each asset class. The one free lunch you get is diversification, and everyone should employ it. From there, make selections that make good common sense. In my view, cash, gold, and bonds are pretty straightforward. Picking stocks is the hard part.

Thank you for reading, and please comment below.

Disclosure: I am/we are long BRK.B, AAPL, GOOGL. 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.

Additional disclosure: I own, and plan to own, investment products mentioned within this article as well as other stocks.