What's the best asset allocation now?

Conditions favor equities but there's value in bonds too

Mar 18, 2014 @ 12:01 am

By Cam Albright

stocks, bonds, interest rates, earnings, multiples, S&P 500
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Looking back at the strong stock market gains of 2013, especially those recorded in the final quarter of the year, many investors could be forgiven for being lulled into thinking that we were in for another robust year on Wall Street in 2014.

Well, January certainly put a chill into those thoughts and while February provided a decent rebound, markets are still unsettled. Through the first two months of the year, stocks, as measured by the S&P 500, gained a whopping 1%.

Faced with such whiplash-inducing events, what is an investor to do? Was the early year volatility a harbinger of a declining stock market or was the dramatic turnaround in February the face of financial markets in 2014?

(See also: Asset allocation for 21st century retirement)

Equities remain our best chosen tactical option

The stock market still has momentum for further gains and we expect a more normal growth environment to help propel earnings higher, leading to further equity gains.

Why?

The global economic recovery should continue despite the slowdown in emerging market growth rates:

• Europe's economy, though still weak and now subject to concerns over the Ukraine, appears to be stabilizing.

• The U.S. economy is likely to continue to grow more quickly, if slowly by historical norms, than most other developed economies.

• The U.S. recovery continues to generate investor confidence, in part because of the rebound in housing.

• We expect U.S. GDP growth will accelerate to 2.5% or better in 2014, as the effects of U.S. fiscal drag decline and housing and business investment continue to increase.

• The Federal Reserve is likely to remain accommodative well into 2015.

Corporate earnings growth is expected to drive equity performance in the coming year:

• Our estimate of S&P 500 Index profits in 2014 is $118 per share, up from an estimated $110 per share for 2013. Our 2014 profit estimate is slightly conservative relative to the consensus forecasts of both top-down strategists and bottom-up company analysts ($119 and $121, respectively).

• We forecast that on Dec. 31, the S&P 500 will be trading in a range of 1,890 – 2,016. The range reflects estimated price/expected earnings ratios of 15 to 16 times and an earnings per share forecast of $126 for the 12 months ending Dec. 31, 2015.

Keep your eyes open

In real life, we know that weather can impact visibility. Fog or blizzard conditions can make it impossible to see very far, creating any number of hazards. This winter's bad weather has made its way into the realm of economics, where data releases — many of which have been below expectations — are quickly dismissed as being impacted by "the weather."

We entered 2014 believing that the economy was well-positioned for growth in the 2.5 to 3.0% range — and still believe that this year will continue the process of normalization from the financial crisis. But we are attentive to the fact that the jury is still out regarding weather being entirely to blame for some of the economic misses we have seen.

Again, as in real life, we will have to wait for the weather to clear from the statistics to measure the full impact and, perhaps more importantly, to see if other factors are holding activity back. However, we still look for growth to be in the 2.5 to 3.0% range as the year progresses, which enables us to remain comfortable with our overweight equity exposures.

Potential value and protection in the bond market

Having produced negative returns last year and still facing the prospect of rising interest rates this year, bonds are considered by many to be a poor investment choice. But we believe that the fixed income market is offering a potential haven in the 1 to 5 year maturity part of the yield curve.

The rationale behind this view stems from comments made by the Federal Reserve and the current shape of the yield curve. The Fed has made it clear that it intends to reduce its quantitative easing program, and that is likely to reduce pressure on longer-term bond yields, allowing them to normalize at higher levels.

At the same time, the Fed has indicated it is likely to keep short-term rates low for some time, probably into the fall of 2015 according to the Fed Funds futures market. The longer end of the curve is likely to move higher but we do not expect the short end to respond in the same way. As a result, investors who have portfolios in the 1–5 year maturity range are less likely to face material principal erosion while picking up income returns that may average 1% for Treasury investors. The same works with investments in corporate bonds or municipals.

But we should also point out that this scenario will not last forever. When the Fed decides to start raising short-term rates, investors will want to reevaluate their portfolios, possibly considering that it may make sense to be positioned further out the yield curve, as the bulk of the damage from rising rates may have already been done to that part of the curve.

Cam Albright is director of asset allocation at Wilmington Trust

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