July 11, 2016: Asset Trend Review

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Asset Trend Review

What a difference the last two weeks made! As it stands right now:

S&P 500 stock index is at all time high
10 Year Treasury bond yield is at all time low
Germany, Japan and Switzerland 10 year government bond yields: negative
Britain, France, Spain, Italy 10 year government bond yields are all lower than the U.S:

What happened after Brexit referendum is that interest rates in all major countries fell with the belief of possible strong central bank support or intervention. Friday’s US job report made investors believe that the risk of US economy weakening is removed and it is now in a robust trajectory. This caused a flurry to buy stocks, pushing S&P 500 to its all time high.

In all fairness, US 10 year Treasury bond yield is still the highest among major developed countries. This is strange as US credit situation is better than that of most of these other countries. However, with all countries are racing to the bottom for yields, investors naturally push US yield further down. Granted, the reasons behind all the asset price movement are more than the above (for example, the currency war is one of the main factors driving sovereignty bonds’ price lower). Nevertheless, what a inter-connected world!

Stock and bond portfolios are all performing well

In such euphoria, it’s not surprising that both stock and bond portfolios are doing very well:

Performance Comparison (as of 7/11/2016):

Ticker/Portfolio Name	YTD Return**	1Yr AR	3Yr AR	5Yr AR	10Yr AR	10Yr Sharpe
Six Core Asset ETFs Tactical Asset Allocation Moderate	7.3%	5.8%	4.4%	4.2%	8.6%	0.83
Schwab Total Return Bond	7.2%	7.0%	4.4%	6.0%	8.8%	1.83
Fidelity Muni Bond Funds	7.4%	12.3%	8.2%	8.7%	7.1%	2.15
VFINX (Vanguard 500 Index Investor)	5.7%	5.1%	11.1%	11.8%	7.5%	0.33
VBINX (Vanguard Balanced Index Inv)	6.0%	5.1%	8.2%	8.4%	6.9%	0.52
VBMFX (Vanguard Total Bond Market Index Inv)	6.1%	6.0%	4.4%	3.6%	5.1%	1.1
VWIUX (Vanguard Interm-Term Tx-Ex Adm)	3.7%	6.5%	5.2%	4.7%	4.7%	1.46

Apparently, bond portfolios have done better than stocks, both in the short term (Year To Date YTD) and in the longer term: 10 year period. In fact, they did that with much less risk. Regardless of how much attention and excitement stocks garner, for the past 10 years, they still can’t beat bonds. What’s more, tax free bonds have done better than taxable bonds (see April 25, 2016: Tax Free Municipal Bond Funds & Portfolios for discussion on tax free bond portfolios).

The road to low return: stagnation and gyration

Now that all of the major assets are at an elevated valuation level, what’s next?

Mean reversion and momentum are the two key factors driving the price of financial securities such as stocks or bonds. Our Tactical Asset Allocation(TAA) utilizes momentum factor extensively. Mean reversion, on the other hand, dictates that the price of a stock or bond will eventually revert back to its mean (average). At this moment, unfortunately, both the prices of stocks and bonds are way above their long term means.

It’s easier to estimate the long term return of a bond assuming one holds it till maturity. At this moment, holding a 10 year Treasury note will return 1.43% (its yield) annually. We have discussed the long term returns of stocks in many of our previous newsletters (see, for example, January 18, 2016: Strategic Asset Allocation: A Cautious Outlook). The most likely annual return of US stocks in the coming 10 years is estimated to be around 2%.

Investors tend to argue that since bond yields are so low, stocks deserve to have higher valuation. The problem or non-problem of this argument is that this has been priced in the current stock price. To the extent that bond delivers 1% or so annual return, stocks, at the current valuation (no one would argue that stocks are undervalued, it’s just whether they are fully valued or way to overvalued), will deliver higher returns than bonds by adding so called risk premium. The theory goes as follows: since stocks are more volatile or riskier, they deserve to obtain extra (risk premium) returns. 2%+ is actually not a unreasonable estimate even along this line of argument since bonds only yield around 1%. Regardless, stocks are likely to deliver lower than historical average returns 10 years later.

In such a low future return environment, the path stocks will take can only be either stagnated (just like what we have observed for the past one plus year) and thus clock in very low return each year. However, history tells us that it’s more likely they will travel in a more volatile and gyrated fashion: they will drop significantly at one point and then recover. For example, from the top on 8/31/2000 in the internet bubble to today, S&P 500 total return (dividend reinvested) VFINX (Vanguard 500 Index Investor) experienced two big drawdowns, losing more than 50% of its value at some point between 2008 and 2009 and recovered to today’s all time high.

Its annual return? 4.1%, compared with 5.2% of bond index VBMFX (Vanguard Total Bond Market Index Inv)!

As always, we do not proclaim that stocks and bonds will decline immediately nor we know precisely when they will fall sharply. In fact, it’s very likely the current up trend will go on for a while. However, the long term path is very clear: danger ahead.

What we can draw from the above discussion is that to obtain higher returns and avoid big losses from stocks and bonds for the coming decade, one has to invest in a more proactive or tactical way. This is true for both stocks and bonds. Fortunately, our tactical portfolios such as those listed in the above table are tactical in nature. For bonds, if a big loss is emerging, these portfolios will rotate to short term bonds or even cash temporarily to wait out the storm.

As stocks and bonds are rising more and more each day, we believe it’s becoming more and more important to overweight in tactical portfolios, both stocks and bonds.

Market Overview

Now that Brexit is behind us (is that really?), stocks and bonds rose to all time high. Along with these two important assets, REITs, gold, international bonds and emerging market stocks all rose strongly too. Risk assets are in a sharp up trend. However, investors now need to face the old fundamental reality that has dogged stocks for so long: earning report for Q2 2016. It is again projected by Factset that earnings of S&P 500 companies will decline -5.6% in Q2 2016. If this projection holds, it will mark the 5th consecutive quarter of earnings decline for S&P 500 companies. So the current stock gain is purely based on yield seeking or racing to the bottom. Regardless, we shall follow our strategies systematically to stay on course.

For more detailed asset trend scores, please refer to 360° Market Overview.

We would like to remind our readers that since the financial crisis in 2008-2009, we have not seen substantial structural change in the U.S., European and emerging market economies. Economies have heavily relied on low interest debts. Capital might be misallocated to unproductive investments and consumption. U.S. stock valuation is at a historically high level. It is thus not a good time to take excessive risk. However, we remain optimistic on U.S. economy in the long term and believe much better investment opportunities will arise in the future.

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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Vanguard ETF:	10%*
Diversified Core:	11%*
Six Core Asset ETFs:	10%*

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