Archive for April 2, 2012

| April 30, 2012
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Market Outlook April 30, 2012

Over the past week, stocks rose about 0.5% and bonds fell about 0.5%. However, stocks still lack momentum, given that the market is 1.2% lower than 50 days ago and 8.3% lower than 200 days ago. Bonds, on the other hand, are 2.2% higher than 200 days ago. Traders (and investors) still seem hesitant to buy risky assets (including stocks). Positive performance is moving stocks back toward positive momentum, but it will still take a little time. Further, last time they approached positive momentum, the following weeks were consistently negative. There are no guarantees that stocks are about to perform well.

The real estate sector, however, has been fairly consistent in producing favourable performance over the past couple months. I will continue to own real estate (XRE) over the coming week. There’s really no other sector that is performing consistently well.

My fair value estimate has risen slightly, along with the market value. Capital remains cautiously deployed, with preference given to the most stable governments and corporations. Now that summer is coming, people will have better things to do than research companies and read financial statements. I hold little hope that the summer months will be better than what we have experienced over the past six months or so.

Category: Stock Market Outlook |
| April 23, 2012
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Market Update April 23, 2012

Over the past week, the market value rose. That’s nice, but it wasn’t necessarily a good week. The increase was less than 1%, and the volatility remains a little higher than in the past. As one might expect, with stocks higher, bonds and gold are lower. Glancing through economic news, it appears to be mixed.

Given the recent weakness, stocks still haven’t built up enough momentum to pull ahead of bonds and, at this rate, it looks like it will take at least a few more weeks. Real estate (XRE) is still the asset class of choice, for the present. That implies that money is flowing into real estate equities, probably from pension and institutional funds that are looking for both a hedge against inflation and some income generation.

The market value estimation continues to adjust based on earnings reports, although it really hasn’t moved much since last week. The market remains almost exactly at my fair value estimate. Optimism has not yet returned. When optimism starts to come back, I expect to see some P/E expansion. Investors who can get in front of it will be positioned to profit.

Category: Stock Market Outlook |
| April 18, 2012
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Strategic Asset Allocation

Last week, I wrote about asset allocation. By far the most common approach is strategic asset allocation. By definition, this is the long-term strategy. How much of a portfolio should the investor allocation to cash, stock and bonds?

Much research has shown that most of the level of return is determined by the choice of asset allocation. The same is true of volatility (which I don’t believe approximates risk). If I choose all stocks, I’ll have stock-like returns (probably higher over a long period of time), whereas if I choose all bonds, I’ll have bond-like returns (probably lower, but more likely to be positive over the short and medium term). If I mix stocks and bonds, my portfolio will act partially like a stock and partially like a bond. This is neither difficult nor surprising.

The only reason to keep cash is to be able to take advantage of buying opportunities or to be able to produce income. Otherwise, cash will only reduce the portfolio return. In the two rare cases where cash might be valuable, it would probably not be best. If people lose faith in the financial system, you’d be better off owning gold (or canned food and a gun). In the case of deflation, you’d probably be better off owning government bonds.

The true decision then is between stocks and bonds. I can think of two reasons to own bonds, either if you require guarantees (like large pension funds) or if you have enough capital that you can afford the lower income bonds (currently) provide. Suppose you have $1 million, but only want $30,000 per year income. Why risk your capital investing in stocks, when you can produce your required income from bonds? In a very large portfolio, an investor may choose to have a certain amount of guaranteed income, perhaps $2000 or $3000 just to cover the very basic lifestyle costs. The rest could come from stocks, but at least if anything went wrong, the bond portion of the portfolio would continue to provide income.

Stocks provide dividend income and long-term capital gains. This combination produces (over a long enough timeframe) higher returns than cash or bonds. Because of my young age and the likelihood that I’ll return to work at some point, I prefer to keep my portfolio 100% in equity. This means I experience the ups and downs of the stock market, but I also earn the returns.

Let’s use an example of a portfolio that is balanced 60% stocks, 35% bonds, 5% cash. Over the course of time, stocks and bonds will perform better or worse. This leads to opportunities to rebalance. Rebalancing will actually reduce returns by selling winners as they continue to grow, while buying losers that are languishing. However, it imposes rigour by helping to buy low and sell high. For someone who is undisciplined, it might produce a sub-optimal return, but a far better return than what they would achieve by jumping in and out of the market.

I don’t believe that there’s much point to strategic asset allocation. I also believe that rebalance produces sub-optimal returns. That’s why I spend more time on tactical asset allocation, which I’ll explore next time.

 

Category: Opinion |
| April 16, 2012
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Market Outlook April 16, 2012

Volatility has risen. This past week, the TSX experienced a large drop (Tuesday), a large rise (Thursday) and ended about 0.5% lower than it began. The total change wasn’t very large, but the ups and downs were greater than we’ve experienced recently.

Bond yields dropped and bond prices rose, while stock values fell. Obviously, that does nothing to reverse the trend of bonds outperforming stocks in Canada. My expectation, a couple weeks ago, that moving from overweight bonds to policy weights of stocks and bonds was not very well timed. Bonds have risen steadily over the past four weeks, while stocks have fallen each week. The real estate (XRE) sector continues to provide good performance and better momentum than any other asset class I follow. As such, that’s what I will continue to own this week.

The market seems to be reacting to a somewhat pessimistic outlook. If Greece is no longer grabbing headlines, it’s Spain or some other countries that may potentially be in an unfixable financial mess. The economic outlook is not rosy, and earning projections are likely falling. Although it’s only an estimate, the stock market valuation currently matches my fair value estimate almost exactly. There is none of the exuberance that existed prior to 2007 (and post 2003). While that’s a little disappointing, it should make purchase prices for stocks relatively attractive. And I always remind myself that I continue to receive my dividends.

Category: Stock Market Outlook |
| April 11, 2012
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Asset Allocation

This is the first in a three-part series about asset allocation. Today, I’ll grapple with what asset allocation is, how it works and why anyone would use it. Next week, I’ll discuss strategic asset allocation in more depth. Finally, I’ll tackle tactical asset allocation.

What is it?

Asset allocation, in its simplest form, means dividing a portfolio between different asset classes. Asset classes are meant to be investments that perform differently. Technically, an asset class should have a negative correlation (one zigs when the other zags) in order to complement each other. Initially, savers saved cash, investors bought bonds and speculators played stocks. Each of those categories are considered asset classes. Over time, investors realized that stocks aren’t purely speculative, and have added them to their portfolio. Investment managers, whether to add spice to their portfolios, or to offer the appearance of sophistication, have multiplied the number of categories of stocks and bonds that are considered unique asset classes. Some examples are: government bonds, emerging market bonds, corporate bonds, high-yield bonds; dividend stocks, growth stocks, value stocks, large cap stocks, small cap stocks, emerging market stocks, and probably others. Beyond these categories, commodities and real estate may be realistically considered additional asset classes.

How it works

Asset allocation, then, is choosing which classes of assets will be included in the portfolio. Different asset classes have different characteristics and are used to meet different needs. Bonds provide income, as well as guaranteed return of capital. They should be used for investors who need income or who want guarantees. Stocks may provide some income, as well as capital growth. They are suitable for investors who want growth and who have a longer time horizon. Cash is not an investment, and is only suitable for bridging short gaps in income or for making future investment purchases. Real estate is useful for current income, as well as a hedge against inflation. Commodities provide a hedge against inflation. Depending on the goals of the portfolio, then, asset classes should be chosen that reflect those needs. For example, a portfolio that is intended to produce income that keeps pace with inflation would likely invest in some bonds, dividend-paying stocks, real estate and possibly a small amount of commodities.

Why use asset allocation?

Besides matching portfolio characteristics to goals, pension funds and investment funds use asset allocation as a method of diversification to smooth investment returns. For example, given that stocks zig when bonds zag, owning 50% stocks and 50% bonds would create a portfolio that is less likely to experience wild swings in value than a portfolio that is 100% stocks with no bonds. Further, if an investment manager equates risk with volatility, he will tell you that he has reduced risk. Increasing the allocation to bonds (guarantees) will always reduce risk, but not because volatility is reduced. As an example, in a portfolio that is 100% bonds, increasing the allocation to stocks from 0% to 5% may reduce volatility (due to negative correlation), but it has reduced guarantees and increased the possibility of loss of capital.

Asset allocation is an accepted part of portfolio construction. However, because my goals include high income and the potential for capital gains, I have allocated 100% of my portfolio to equities (much of which represents real estate). I don’t mind big swings in value, because fluctuations don’t affect my income. I would only buy bonds if I needed guarantees, or if I had more money than I need for my stock portfolio.

Category: Opinion |
| April 9, 2012
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Market Outlook April 9, 2012

The TSX was closed on Good Friday, so it was a short week. Short and negative. Stocks ended the week more than 2% lower than at the start. In all honesty, I’m surprised. I thought the market was on the verge of resuming optimistic growth. Strangely, however, stocks and bonds both fell in value. The only bright spot of news was that my decision to ignore my asset rotation signal worked out. Becuase real estate and emerging markets showed similar levels of momentum, when the latter pulled slightly ahead of the former, I chose not to act. Real estate (XRE) outperformed over the last four days, being the only index to advance, and it is again the asset class to own over the coming week.

 

Category: Uncategorized |
| April 6, 2012
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Market closed for Good Friday

The TSX is closed today. I have a couple posts I’ve been meaning to write, about asset allocation and about Pembina, which looks attractive. Unfortunately, I’ve been really busy, and I have to complete my tax return before I can return my focus to writing opinion and research.

I hope you all have a very Good Friday and an enjoyable long weekend. I’ll have a market outlook ready for Monday.

Category: Uncategorized |
| April 2, 2012
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Market Outlook April 2, 2012

For another week, stocks have fallen while bonds have gained. Stocks are about 0.5% lower, but bonds rose about 0.5%. There may be a couple reasons for this, but it reinforces the idea that money isn’t flowing freely into stock market investments at this time. In perusing financial news headlines, I came across a couple articles that argued institutional investment managers are directing funds towards equities, and now it’s time for individual investors to follow their lead. On balance, I’m not sure that’s true, since it appears that confidence in risky assets is still low. It’s difficult to explain why bond yields continue to drop, unless investment managers (in aggregate) continue to prefer bonds.

Last week, I suggested that an investment account that is balanced between stocks and bonds should return to policy weights. I continue to hold that opinion. Stocks’ momentum has yet to surpass that of bonds, but they are approaching equilibrium. It appears that now may be the time to take profits from bonds, in anticipation of future flows of capital. For a portfolio that rotates between asset classes, the signal has changed from real estate back to emerging markets (XEM). The difference however is slight, so I won’t place the trades this week in order to keep down trading costs. Actually, XRE performed very well last week, better than any other asset class, so I hesitate to sell it (which I realise is an emotional reaction).

My fair value estimate for the stock market continues to fall. I wonder if companies continue to report disappointing earnings. The stock market is now discounting 12 month earnings growth of 8%, implying that companies need to report 8% higher earnings in 12 months to justify current prices. Comparing the TSX to other stock markets is instructive. From 2007 to 2011, Canada’s TSX outperformed the stock markets of other countries. Over the last year however, the leading stock markets (Canada, Mexico, Brazil) have underperformed while other markets have caught up (S&P 500, Dow Jones, Europe). It’s time for me to add additional geographic sectors to my asset rotation model.

Category: Uncategorized |