July 2011 Asset Allocation Model Update

As has been the case for well over a year now, the asset allocation model that I built and have been tracking for quite some time indicates that a split of 80/20 stocks vs. bonds is still called for in these circumstances.

Though valuations on an absolute basis are not as attractive as they were at this time last year, the slope of the yield curve, combined with very low interest rates continue to provide a strong case for equities. If you look at the past year and a couple of months since we inaugurated it, I think it has been generally correct, though it has been limited to recommending an 80% equity asset allocation:

Since the beginning of the tracking period, the S&P 500 has outperformed long-term bonds by about 1500 basis points. There was a stretch in the summer of last year that I regretted that the model could only go to 80% stocks since the readings were off the charts recommending buying equities. Part of the reason the model has been stuck at 80% in stocks for so long is that it shot so far above the threshold that even though it has since come down somewhat, it is still over the line for 80% in stocks. I may refine the model somewhat to allow for rare cases where you should go "all in" because there are a number of times in the history of the financial markets where that is called for. Conversely, there are times where having just about no equities also makes sense. This, however, is not one of them.

The bottom line is that the comparative case for allocating your money to equities and away from fixed income instruments is very very strong right now.

The crazy(?) bond rally

Over the past four weeks or so, the bond rally has become truly epic. I have been truly stunned by the magnitude of it.

Here is the oft-mentioned TLT, which tracks the 20 and 30 year US Treasuries.

It's charted against SPY (the S&P 500 proxy) and EEM (the emerging markets proxy). To show that the bond rally has some breadth, let's look at municipal bonds as well. Now, the MUB is not just a long maturity municipal bond fund but rather a larger aggregate so its moves aren't as dramatic, but it tells a similar tale.

The same had also held with corporates, as represented by LQD, which tracks long term investment grade corporate debt.

Now, the question that many are asking is "Is this a bond market bubble?" Well, current interest rates do seem absurdly low. In terms of the stock market, it would be the equivalent of paying 40x earnings for a company's stock (the equivalent of a 2.5% earnings yield). However, with inflation also at historic lows, the bubble might not be as big as some are claiming. If you are of the view that inflation will soon accelerate to 4%+, then yes, bonds are dramatically overvalued. If you believe instead that inflation will be between 0% and 1.5%, the overvaluation of bonds ranges between not much and only marginally overvalued. I do happen to think that, when you look at comparative stock market measures, bonds are at least moderately overpriced. That holds true so long as corporations will be increasing their earnings even at a moderate pace over the next several years.

With the Fed possibly embarking on more quantitative easing (the direct purchase of treasuries to increase the money supply), one might wonder if interest rates will be capped at these low levels or even drop further. The last time the Fed did a similar action, interest rates rose anyway because market expectations of an economic recovery picked up. At this juncture, it's hard to say which way they will go, but I think that past performance might be a decent indication. Quantitative easing is a powerful stimulative tool and if the Fed is zealous in its application, it actually might actually have the net effect of increasing interest rates through market expectations of higher growth. All of this remains to be seen, however.

The Peculiar Allure of Gold: Part 1.1

Some time recently, we discussed here some of what seems to drive the price of gold.While all of the other arguments for owning gold are generally a pile of crap, I had noted that over time there did seem to be an inverse relationship with the value of the dollar under most circumstances. However, I would note of late that it seems that even this relationship has broken down.

This is a simple picture (click on it to enlarge):

What you are seeing there is a 3-month chart of the ProShares US Dollar Bullish Fund (UUP), which has leveraged bullish bets on the US dollar vs the SPDR Gold Trust (GLD) which tracks the price of gold. You might note that there is a positive correlation between the dollar and the price of gold. Wait... what?

Well, maybe for the past three months gold has been a bet against the Euro while over the long run it is a bet against the dollar while also being an inflation hedge while also being a crisis hedge while not doing a particularly good job reflecting any of those relationships! I think there is a simpler reason for the decline of gold recently and that is that as it is clear that there is no risk of accelerating inflation, probably the number one reason scared little Glenn Beck listeners have been hoarding gold has been undercut severely. By the way, bashing on Glenn Beck is not in violation of this blog's no political discussions rule since Glenn Beck's insanity transcends ideology. He gives investment advice and it is damn bad advice at that.

For instance, while things have gotten rough over the past few months and U.S. deficits are in the stratosphere, surely you wouldn't want to invest in worthless pieces of paper like U.S. Treasuries and instead would want the safety of gold, right? Wrong. Very wrong. Stupidly wrong.

TLT, our long term treasury proxy, kicked the hell out of GLD over the past three months while stocks, represented by SPY here, suffered as we all know. It is interesting to note that some gold bulls had maintained that stocks and gold must necessarily rise together because... um... well because they said so, that's why. Never mind that this is a relationship that has never really held except for brief periods when it seems to out of pure coincidence. Recently stocks have rebounded more sharply than many give them credit for while gold has been in a trudging decline.

Gold currently is trading in such a peculiar way that it is helpful to think about the following. Currently, gold is not trading in accordance with any clear rational relationship to, well, anything. If the rationale for investing in an asset is not clear, then you should not invest in it. I can easily spell out why equities are good buys at present levels based on well accepted empirically derived relationships. Gold, it is not so easy unless you truly believe that we are about to undergo a period of 10%+ inflation, which I do not and the markets do not either except for the gold bugs who are always and everywhere trapped in a particularly pernicious insanity.

It may well be that gold gets foisted to new highs by irrational markets, but I would wager that in the next five years gold will be beaten by just about everything, including housing.

Threading Strategies Together

Several different strategies have been discussed here on Finance Monitor along with numerous individual investments and I thought I would provide some context on how to view the discussions in the context of your own investments. The fundamental goal of this post is to weave several different posts on different subjects together. I will try to provide links so that you can quickly look up the prior discussions.

I guess the proper way to start this conversation was with the prior post on risk reduction in portfolio construction. This is one way of looking at your macro strategy, though there are many potential variations on this broader strategy. Within the core portfolio, either use equity index funds or balanced funds and basically just try to keep your overall allocation right, unless you want to be a little more active here. Then, you can engage in what was discussed on the post on dynamic asset allocation.

To do this, use the SPY and TLT ETFs at a basic level. If you have less than $2,000, I strongly encourage you to only re-balance when interest rates suggest you make a large reallocation from stocks to bonds or bonds to stocks. If you re-balance with every twinge, you'll get eaten alive by commissions. For example, let's say the model changes each month and you re-balance with $7 commissions each time (on both purchase and sale) with a $2,000 balance. You will incur $14 a transaction 12 times for a total of $168 in commissions. That would be 8.4% of your portfolio or greater than your average annual gain. With $20,000, it's 0.84%, which is bad, but not ruinous. If you are so fortunate to get up to $100,000, the fees are very low indeed. The ETF fees for TLT and SPY are also very low. In the case of SPY they are 0.09% per year and 0.15% on TLT.