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Does Traditional Asset Allocation Still Work – and Will It Survive?

“All courses of action are risky, so prudence is not in avoiding danger (it's impossible), but calculating risk and acting decisively. Make mistakes of ambition and not mistakes of sloth. Develop the strength to do bold things, not the strength to suffer.”
Niccolò Machiavelli

After years of research and experience in the investment market, I have seen how today’s market has been strongly influenced by the easy money policies that central bankers pursued since the beginning of the Great Recession in 2008. Almost all financial assets tend to increase in value when interest rates decline, while asset prices become strained or even fall when interest rates rise. Since 1981, US 10-Year Treasury yields have fallen from a peak of more than 15% to an all-time low of less than 2%. (Source: https://yhoo.it/2hKKhrl) This has created a tailwind for investments and economic activity for the last 35 years. Modern Portfolio Theory suggests that diversification and spreading out your risk is the best way to balance risk/reward, but what happens when asset prices on stock, real estate, and bond instruments are pushed in the same direction? For the last 3 decades, investors would have done quite well in traditional assets allocations such as the 60/40 portfolio (60% stock, 40% bonds).

But does traditional asset allocation still work?

Since the 1981 peak to present, a portfolio holding 60% US stocks (S&P 500) and 40% US 10-year Treasury allocation has outperformed the 3-month Treasuries by 6.4% per year. However, during periods of interest rate increases (1964-1981) investors in the same 60/40 portfolio would have lost 1.4% per year compared to short-term treasuries.

(Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html)

Investors also seemed to have quickly forgotten the risk associated with an all stock portfolio as the market continues to hit all-time highs. According to the Shiller Cyclically Adjusted Price-Earnings ratio CAPE), stocks have only been at or above current stock market valuations twice in history: the Tech Bubble of the late 1990s and the Great Depression. 

(Source: multpl.com)

However, we do not want to paint the picture of complete doom and gloom. Some have argued that the CAPE index has flaws of its own in that it looks back at earnings over a 10 year period. This would include low earnings leading up to the Great Recession in late 2007. As the years move on, earnings history should improve and should allow stock prices to move higher without increasing the valuation so much on the CAPE index. (The higher the valuation, the more over-priced the market is perceived to be) 

According to JP Morgan, the expected average 5 year subsequent return of the stock market will most likely be in the single digits.

As rates start to reverse and lending costs go up, economic activity will most likely feel a pinch or even a loss of wind felt from a gut punch. Therefore, it is important to start thinking outside of the box, which is why we feel non-traditional asset allocation is important. Some Investors, individuals and even seasoned professionals may tend to move in a herd mentality. Some financial advisors might be afraid to do things different from others because it is safer to be with the crowd than to be an outlier. Using the JP Morgan Long-Term Capital Market Assumption (5 years), we expect that traditional asset allocations will return 3.4% or less when costs and distributions are taken into consideration. Obviously there is no crystal ball and estimates cannot be exact. However, our view is that using active management (tilt, multi-asset, managed volatility, Long/Short strategies and certain alternatives) will give a better chance of achieving a return of 4%-7% (what most investors need to help fund their retirement and keep up with cost of living) over the next 5 to 10 years over static and passive index strategies.

The last ten years has been great for passive index strategies which is why so much money has flooded into ETFs and passive index mutual funds. However, there is an inherent danger to this also in that the masses are moving in the same direction together. Rather than follow the masses, we will be actively looking for yields in non-traditional asset classes. 

As the world of investing tries to consolidate and pile into passive investing strategies and simple asset allocations driven by automation, we will strive to move our investors in the opposite direction. This may result in performance that does not move in lock step with market expectations from time to time, but we feel that thinking out of the box will be required in order to help clients attain their long-term retirement goals.

The Federal Reserve Chairman, Janet Yellen has indicated that the Fed will start reducing their balance sheet that has ballooned with massive debt purchases over the last decade. As the Fed changes course, we expect disruptions to the capital markets. Currently, we view global asset prices to be more attractive in valuation than US markets and encourage a global diversified portfolio.

What is an investor to do?

Some may feel that sitting out of the market, for now, is the only option, but inflation and markets are extremely unpredictable. It is unlikely that market and economic anxiety will feel relaxed any given point in time. Uncertainties are most likely to stay for quite some time and trying to time interest rates, market behavior, and political changes will most likely result in worse off results than a long-term investment strategy.

The key to successful investing will be in a disciplined investment process that does not react over short-term emotions, but rather focuses on long-term fundamentals. This is where a strong relationship with a seasoned wealth advisor can pay dividends. We at Chatterton & Associates are always looking to strengthen our process and developing strong relationships. 

 

Eric Oh, ChFC®, CFP®

Chatterton & Associates, The Wealth Management Team, Inc.

Chart 2: Source: FactSet, Reuters, Standard & Poor's, J.P. Morgan Asset Management. Returns are 12-month and 60-month annualized total returns, measured monthly, beginning June 30, 1992. R2 represents the percent of toal variation in total returns that can be explained by forward P/E rations. Guide to the Markets - U.S. Data are as of June 30, 2017.

Chart 3: Source: FactSet, J.P Morgan Asset Management; (Top) Ibbotson, Standard & Poor's; (Bottom) Alerian, BAML, Barclays, Clarkson, Drewry Maritime Consultants, Federal Reserve, FTSE, MSCI, NCREIF, Standard & Poor's. Dividend vs. capital appreciation returns are through 12/13/16. Yields are as of 6/30/2017, except maritime and infrastructure (3/31/17). Maritime: Unlevered yields for maritime assets are calculated as the difference between charter rates (rental income) and operating expenses as a percentage of current asset value. Yields for each of the sub-vessel types above are calculated and the respective weightings are applied to calculate sub-sector specific yields, and then weighted to arrive at the current indicative yield for the World Maritime Fleet; MLPs; Alerian MLP; Preferreds; BAML Hybrid Preferred Securities; Private Real Estate: NCREIF ODCE; Global/U.S. REITs: FTSE NAREIT Global/USA REITs; Infrastructure Assets; MSCI Global Infrastructure Asset Index; Convertibles; Barclays U.S. Convertibles Composite; EM Equity; MSCI Emerging Markets; DM Equity; MSCI The World Index; U.S. Equity; MSCI USA. Guide to the Markets - U.S. Data are as of June 30, 2017

Chart 4: Source: Federal Reserve, FactSet, J.P. Morgan Asset Management. *Balance sheet reduction assumes reduction from currecnt level, beginning October 2017 and lasting four years, concluding in October 2021. Reduction of Treasuries and MBS is per FOMC guidelines from the June 2017 meeting minutes: Treasury securities will be reduced $6 billion per month initially and reduction rate will increase in step of $6 billion at three-month intervals over 12 months until reaching $30 billion per month; MBS will be reduced $4 billion per month initially and reduction rate will increase in steps of $4 billion at three-month intervals over 12 month until reaching $20 billion per month; other assets are reduced in proportion. Forecasts do not take into account months where maturing assets do not exceed the stated cap nor do they consider the reinvestment of principal or interest repayment in excess of the stated cap. Guide to the Markets - U.S. Data are as of June 30, 2017

RISKS AND DISCLOSURES

The views contained herein are not to be taken as an advice or recommendation to buy or sell any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without previous notice. All information presented herein is considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. This material should not be relied upon by you in evaluating the merits of investing in any securities or products mentioned herein. In addition, the Investor should make an independent assessment of the legal, regulatory, tax, credit, and accounting and determine, together with their own professional advisers if any of the investments mentioned herein are suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield may not be a reliable guide to future performance.

Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values

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