Trade Talk

September 20, 2011

We’ve made trades our two model portfolios on September 20th to reflect 1) the market slide this year, and 2) increasing distaste for stock funds by investors, who are usually wrong.

Broadly speaking, these changes will increase our stock allocations by 5% – from 45% to 50% in our Conservative portfolio, and 65% to 70% in our Aggressive portfolio

We're also moving slightly away from U.S. growth stocks and small caps, more toward harder-hit foreign markets, and away from shorter-term bond funds into longer-term bonds. These moves should give us more upside when stocks recover, but also offer decent protection from a slowing economy with falling inflation. We're also making a small, high-risk bet against oil prices as protection against another recession in our aggressive portfolio.

We don't consider these portfolios very aggressive at this stage, and can increase our stock allocations if the market declines more and investors continue to bail out of stock funds (as we did in 2008-2009 during the big stock slide).

There are plenty of reasons to avoid stocks today. The economy appears to be hitting a soft patch, which is troubling considering it was never really in a hard patch following the last recession. The economy never heated up enough to work through the unemployment rolls, much less cause the widely feared high inflation. Then there's the perpetual news out of Europe that we're on the edge of some sort of contagion that will surely spread and knock 50% out of global stocks, etc.

All of this has drawn more than half a trillion dollars (more than the debt of Greece) into bond mutual funds since early 2009. Meanwhile, nearly $200 billion has exited stock funds over the last 3 years or so, despite a decent market recovery following the big dive in 2007-2009. $40 billion came out of stock funds in recent months, about as bad as what happened in 2010 after a big yet brief drop in stocks that preceded a roughly 30% rise in stocks. Some of the money returned to stock funds near the top. 

Part of this nearly perpetual sourness on stocks, which we've written about here, is just a "no mas" attitude in which investors view stocks as a losing game with minimal upside and frequent 25%-50% dives along the way. Although this has been the case since the top of a historic stock bubble, it's unlikely the next 15 years will progress like the last fifteen have. Even if they do, bonds and money market funds are now yielding so little that even sub-sub-par long-term stock returns will beat bonds and money market, unlike in 2000, when high yields could still be had in fixed income. 

Some of the outflows may have to do with demographics and standard stock bond allocations from aging baby boomers that can’t handle more big hits to their portfolio and therefore have to shift to the slow hit of no return in money markets. This isn’t a smart move if everybody does it and bonds become perpetually overpriced.

We expect about a 5-6% long-term growth rate in stocks with dividends from these levels. That's far worse than what today’s bulls are still calling for – a permanent return to double digit returns because, well, it's happened in the past, yet still higher than the increasingly sour-on-the-U.S.-economy amount individual and professional investors alike are anticipating . Our stock forecast is quite spectacular, compared to the 2-3% returns we expect in bonds. 

While we're selling down our bond funds a bit, we're moving into longer-term bond funds, which carry a great degree of risk if rates go up. This is a move we should have made a year ago in our model portfolios, (and we've written about the attractiveness of longer-term bonds here) because this great rising-rate fear has been overblown for years now. The real risk is Japanese-style deflation, in which case a 6% long-term bond (now more like 4%) would seem like a great missed opportunity. We actually hope rates go up, because that would likely make our stocks perform better as the economy improves. More likely, rates will stay where they are, with short-term rates at or below inflation. 

Our bigger moves into Europe and Japan may seem even more ill-fated, and could be in the short run, but these areas are scaring investors sufficiently to generate better long-term returns.