Asset Class Summary: Fourth Quarter 2014
As in recent years, we believe stocks will continue to outperform bonds and cash. Money market rates and bond yields bouncing along at all-time lows will serve as wind to the sails, and the subdued global recovery will keep rates low. Low oil prices will translate to lower corporate input costs and also help business profitability.
U.S. stocks are fairly valued now and there is concern in the investment community that Price to Earnings (P/E) ratios are not cheap anymore. But we don’t believe they are adequately factoring in the considerations mentioned above, particularly the ultra-low interest rates which make historical comparisons challenging. The current P/E ratio of the S&P 500 is 17 which is slightly above the long-term historical norm. The Shiller P/E ratio is about 27, well above a comfort level of about 20. The Shiller ratio however, is skewed upward by the input of 2008’s extremely low earnings of $0 per share.
Because U.S. equities are not cheap, we prefer having exposure to larger cap names with more stability and historically less volatility. Therefore, we have less exposure to small cap and mid-cap names than we might otherwise.
Regarding international stocks, the EAFE Index has underperformed the U.S. market for the last couple of years and they are more reasonably priced, some might even say cheap. As a result of this, and for the sake of diversification, we are maintaining an exposure to international stocks of about one-third of the typical client’s overall equity exposure. So if a client portfolio has 50% allocated to stocks overall, then 17% of their overall portfolio would be in International holdings.
Although we outperformed in our U.S. equity exposure for the year, the negative return of international markets dragged our equity numbers down somewhat. We think U.S. returns will likely be less robust this year and that international returns will improve somewhat so that in 2015 there will be less disparity between the two.
In our opinion, bonds are expensive; therefore their yields remain very low. Prices keep rising though and interest rates and the yield curve keep dropping. Some day we may look back in amazement on these times of ultra-low rates. Some feel that we may be in this low rate environment for several more years to come due to forces such as global overcapacity and the aging demographics of major developed countries such as the U.S.
Investors were rewarded in 2014 for taking more risk and buying lower rated bonds on longer dated maturity bonds. We underperformed due to our more conservative holdings which are short- dated maturities and higher grade securities. In 2015 we may underperform again if interest rates still don’t start rising towards more normal levels.
Hedged Equities and Alternatives
Our hedged equities and alternative holdings are less correlated to and less volatile than the stock market. Going forward, particularly if interest rates stop dropping and begin to normalize, we believe they will provide greater returns than bonds. While the amount of hedged equity and alternatives exposure varies by client preference and profile, in general we are heavier in these asset classes than we might normally be and lighter in bonds than we might normally be, due to our current outlook regarding interest rates.
Refer to the chart "Balanced Strategy" for the current asset allocation of SHWM’s typical client.
Other articles that appeared in the Fourth Quarter issue of Your Family CFO Report include Economic Overview and Market Overview. Please call us anytime with questions at 404-874-6244 and feel free to pass our message along to friends.
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.