Asset Class Summary: First Quarter 2015
Asset Class Overview. A look at stocks, bonds, hedged equities and alternatives in the first quarter of 2015.
While we continue to hold the majority of client stock portfolio in U.S. based holdings, foreign valuations are starting to look more attractive, and we anticipate better returns from international stocks (both developed and emerging) than we have seen in the past few years (charts 1 and 2 below).
U.S. valuations are on the high side of “fairly valued”, especially when historically high profit margins begin to normalize (chart 3 below). This could be driven by any number of reasons like higher wage growth, which has been muted for some time, or continued strength of the U.S. dollar.
According to research firm Litman Gregory, the median P/E ratio of the S&P 500 is about 21, a significant premium to the 50-year average of about 17 times. The market has been at much higher levels before, and we remind investors that prices often continue on past rational highs (and lows) for some time. That is certainly possible this time, given the still large amount of cash on the sidelines. According to the Federal Reserve, as of 2013 just 13.8% of U.S. families held any direct stocks, down from nearly 18% in 2007. Even indirect ownership, which includes 401(k) plans, mutual funds and pension funds, is in decline. We view this as bullish for future stock prices. Lack of enthusiasm by retail investors is not indicative of a bubble, and stocks climb a wall of worry, which we certainly have our share of globally. At some point we expect a meaningful correction to U.S. stocks, which will bring the P/E ratio down to more attractive levels. As of the beginning of the quarter, emerging market stocks looked even less expensive, with a forward P/E ratio of 11.
In summary, over the next few years we expect lower returns on U.S. stocks, and potentially better returns from international holdings. Despite this outlook, stocks on the whole remain more attractive than cash and bonds, and this view is expressed in client portfolios.
Hedge Equity and Alternatives
The HFRX Equity Hedge Index returned 2.2% for the quarter, just shy of the 2.7% return of global stocks (FTSE Global All Cap Index). Remember that our goal for Hedged Equity is to experience less upside and downside than stocks, thus hopefully smoothing the ride of the market over time. The HRFI Fund of Funds Composite Index, which tracks various alternative strategy hedge funds, returned 2.5% for the quarter. Most clients continue to have meaningful allocations to both Hedged Equity and Alternatives, due to our lack of enthusiasm for bonds, and our mixed outlook for stocks. U.S. stock returns (S&P 500) for the past one, three and five years annualized have been above their long-term averages, so we expect muted returns from stocks for a while going forward. International stocks, as measured by the MSCI EAFE Index, have compounded at less than half the rate of U.S. stocks over the past five years (6.2% annualized for the EAFE vs. 14.5% for the S&P 500). Over time, we expect both to revert back to their long-run averages (closer to 10% for each).
The Barclays U.S. Aggregate Bond Index yields an unattractive 1.9%, barely ahead of inflation. Thus, we remain underweight bonds in most client portfolios. Furthermore, we are still focusing mostly on shorter-term bonds, which offer more protection than long terms bonds when rates eventually rise. This has been painful during the past twelve months, when rates have continued to fall, but we remain focused on our number one long-term goal for bonds, which is to offer stability against the volatility of our stock investments.
Below is an overview of the asset allocation for a balanced strategy portfolio, first quarter 2015.
Please contact Tim Agnew at 404-874-6244 with any questions or for additional information.
All references in this publication referring to our average allocation or “typical portfolios” reflect those of the fully discretionary accounts of clients with moderate risk profiles. Actual client portfolios are tailored to individual client circumstances and asset allocations may vary. Any reference to returns reflect the performance of asset classes, are for illustration purposes only, and do not reflect the returns of any specific investment of Smith & Howard Wealth Management. No representation is made that any investment decisions discussed herein have been profitable in the past or will be in the future. Past performance is no guarantee of future results. A list of all recommended investments is available upon request.