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Wednesday, April 19th, 2017

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Equity Market Conditions Assessment & Portfolio Allocation Intentions 2017-03-17

Monday, March 13th, 2017

This note has three parts:

  1. Short summary of our current market view and portfolio allocation implications
  2. Bullet point outline of details behind our thinking in 5 segments (Trend, Valuation, Sentiment, Breadth, Forecasts)
  3. Supporting graphics for most of the bullet points provided in 24 charts and tables.

The short summary is of our market view and intended allocation actions for discretionary accounts, and recommended actions for coaching or “prior approval” accounts

For those of you who want a feel for why we have our market view and why we believe the allocation changes are appropriate; the bullet points will help.

If you want to see what data is behind most of the bullet points, you will want to look at the 24 supporting graphics.

There is an unfortunate need to use some jargon in the bullet points and graphics which may be unfamiliar to some of you, so please call or write in to have any of them explained; and to discuss their significance to portfolio decisions.

THE SHORT SUMMARY …………

Major world equity markets are in up trends — but there is mounting evidence that the US markets are over-extended and significantly vulnerable to a meaningful downward adjustment based on a combination of valuation, breadth, possible turmoil from key elections in Europe; and as Goldman Sachs puts it “rhetoric meets reality” in Washington.

Downside risk exists, but while the trend remains upward, we are remaining invested.  However, we are not committing additional assets from cash positions to US equity risk positions at this time (except for dollar-cost-averaging programs) due to the elevated vulnerability of the US stocks market.  We will be transferring some of the US equity risk assets in portfolios to some international markets that are in intermediate-term up trends that offer better valuation opportunities.

Portfolio changes or recommendations will be framed within the strategic allocation policy level of each client which varies based on individual needs, goals, stage of financial life, preferences, risk tolerance, and other limits or factors.

Based on valuation and long-term forecasted returns, US stocks exposures will transition from the higher end of individual portfolio policy allocations to the long-term strategic objective levels, or a bit below.  We are currently underweighted non-US developed markets and emerging markets allocations, which we will gradually raise to the long-term strategic allocations levels of each individual portfolio’s allocation policy.

Emerging markets have a more attractive valuation level than other non-US international stock markets (although they pose significantly more volatility), and allocation to them may be raised somewhat above strategic target levels within individual permitted allocation ranges.

For determination of intermediate trend status, we relay on our monthly 4-factor indicator. For more information about our trend following indicator and its performance implications, click here to see our descriptive video.

THE BULLET POINTS …………

  • TREND (see Figures 1-6): The intermediate-term stock trends are:
    • United States – UP
    • Non-US Developed Markets – UP
    • Emerging Markets – UP
  • VALUATION (see figures 7-12): Based on history:
    • United States – Expensive on Price-to-Book and Price-to-10yrAvEarnings and not expensive when earnings yield is compared to Treasury yields.  However, when rates rise the comparison will worsen, making stocks more expensive.
    • Non-US Developed Markets – Moderately expensive on Price-to-Book and moderately inexpensive on Price-to-10yrAvEarnings
    • Emerging Markets – Significantly Inexpensive on Price-to-Book and Price-to-10yrAvEarnings
  • SENTIMENT (see Figures 13-17): for US stocks are:
    • Institutional Investors – are reducing equity allocations (a Bearish indication)
    • Investment Newsletter Writers – Bullish at record high levels (a Bearish contra indication)
    • Individual Retail Investors – strongly Bearish this week but neutral last week
    • Options Market – complacent to mixed (jargon terms defined below):
      • Volatility Index – below 200-day and long-term average (complacent, expects smooth ride next 30 days)
      • Skew Index – above 200 day average and long-term trend line (nervous about possible large downside move, next 30 days)
      • Individual Equities PUT/CALL ratio – is 9% above its 200-day and its 10-year average (more cautious that institutional investors)
      • Index PUT/CALL ratio – is 7 % above 200-day average and 4% below its 10-year average (cautious but mixed signal)
  • BREADTH (see Figures 18-21) the trends are:
    • Percent of S&P 1500 stocks in Correction, Bear or Severe Bear have decidedly turned up (Bearish)
    • Percent of S&P 1500 stocks within 2% of their 12-month highs have decidedly turned down (Bearish)
    • The net flow of money is into S&P 1500 stocks over 3 month, 6 months and 1 years, but the leading edge of those flow has turned down
    • The net flow is explained by the net Buying Pressure declining substantially more than the Selling Pressure; and both measures are at levels below the 12-month average indicating reduced overall force driving the market
  • FORECASTS (see Figures 22-24):
    • “Street” consensus 2017 S&P 500 earnings growth 8.9% on revenue growth of 7.2%
    • “Street” consensus 2018 S&P 500 earnings growth of 12.0& on revenue growth of 5.1%
    • Consensus 3-5 year earnings growth for S&P 500 is 8.89%
    • Consensus 3-5 year earnings growth for MSCI non-US developed markets stocks index is 8.76%
    • Consensus 3-5 year earnings growth for MSCI emerging markets stocks index is 10.37%
    • Consensus 3-5 year earnings growth for MSCI core Europe stocks is 8.11%
    • Consensus 3-5 year earnings growth for MSCI Japan stocks is 9.43%
    • Consensus 3-5 year earnings growth for MSCI China stocks is 7.13%
    • Bank of America/Merrill Lynch just raised its 2017 S&P 500 price target from 2300 to 2450
    • Research Affiliates (leading factor based investor) forecasts 10-year real (after inflation) returns:
      • US large-cap stocks 0.7% (with 14.4% volatility)
      • US small-cap stocks 0.5% (with 19.6% volatility)
      • Non-US Developed Markets stocks 5.4% (with 17.0% volatility)
      • Emerging Markets stocks 7.0% (with 23.3% volatility)
    • GMO Bearish Mgr (lowest min fund investment $10 million available) forecasts 7-year real returns
      • US large-cap stocks – negative 3.4%
      • US small-cap stocks – negative 2.7%
      • Large International stocks – positive 0.2%
      • Emerging Market stocks – positive 4.1%
    • BlackRock (fund manager in the world) forecasts 5-year nominal returns
      • Large US stocks 4.1% (with 15.5% volatility)
      • Small US stocks 4.1% (with 18.7% volatility)
      • Large International stocks 5.5% (with 18.5% volatility)
      • Emerging Markets stocks 5.5% (with 23.3% volatility)

Options Jargon Description:

VIX: VIX is the options pricing implied volatility of the S&P 500 index over the next 30 days, based on at-the-money options

SKEW: SKEW measures the relative options “implied volatility” (essentially price) of S&P 500 out-of-the-money PUTs versus out-of-the-money CALLs with strike prices the same distance from the market price – essentially measuring the perceived “left tail risk” (tail risk is the probability of prices going below the level that is predicted by a normal probability Bell curve).

Portfolio managers are predisposed to buy PUTs for protection and sell CALLs for yield, which tends to increase out-of-the-money PUT premiums and depress out-of-the-money CALL premiums.

SKEW of 100 means the market expects equal implied volatility (essentially prices) for out-of-the money PUTs and CALLS.  SKEW greater than 100 means the market expects higher implied volatility (prices) for PUTs relative to CALLS – more perceived large downside risk.

The record low SKEW was 101.9 on March 21, 1991. The long-term average SKEW is around 115, and the high is around 150. The current 200-day average SKEW is about 130, and the current level is about 140. That means there is a heightened concern about a greater than typical risk of a large downside move in US stocks.

INDIVIDUAL EQUITIES PUT/CALL RATIO: The Equities PUT/CALL ratio is the PUTs volume divided by the CALLs volume on individual stocks. This tends to be reflection of actions by retail investors; and is often a contrary indicator.

INDEX PUT/CALL RATIO: The Index PUT/CALL ratio is also the ratio of the volume of PUTS and CALLS, but tends to be a reflection of the actions of institutional investors; and is not considered a contrary indicator.

THE SUPPORTING GRAPHICS …………

(click images to enlarge)

TREND

FIGURE 1: 
Over the past year, US stocks (VOO), non-US Developed Markets (VEA) and Emerging Markets (VWO) are generally in an up trend, although the US is way out front.

2017-03-13_00
FIGURE 2:
Over 3 years, the three regions are up, but the US is way ahead, and did not have as severe down moves as the other two regions.

As you will see the outperformance by the US is related to its current overvaluation, and the weaker performance of the other markets, is related to their more attractive valuation.
2017-03-13_01
FIGURE 3:
Our 4 factor monthly trend indicators ranks each of the three regions as in an up trend.
2017-03-13_02
FIGURE 4:
This time series of our trend indicator for the US shows the up trend established since March 2016.
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FIGURE 5:
The up trend in non-US Developed Markets was established in November 2016.
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FIGURE 6:
The up trend in Emerging Markets was established at the end of December 2016.
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VALUATION

FIGURE 7:
On price-to-book basis the US is very expensive (at the top of its 10-year range). Non-US Developed Markets are “normally” valued (at just above their median level). Emerging markets are inexpensive (price significantly below their median level).
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FIGURE 8:
In terms of the Shiller CAPE Ratio (price vs 10-year inflation adjusted average earnings), the US is very expensive relative to is long-term history. Developed Markets are inexpensive, and Emerging Markets are significantly inexpensive.
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FIGURE 9:
Based on a variety of valuation metrics the US is expensive. The Developed and Emerging Markets inexpensive by comparison.  Emerging Market have more attractive valuations than the Developed Markets.

In terms of profitability, the US is tops, which partly explains the higher valuation. Developed Markets are less profitable than Emerging Markets.

Emerging markets have competitive dividend yields and the lowest payout ratios.

Emerging markets seem to be a bit less leveraged than US stocks, and the Developed Markets are the most levered.
2017-03-13_08
VALUATION of US ALONE ….

In addition to the price-to-book and Shiller P/E to their respective histories, several other valuation metrics for the US should be considered; almost all of which suggest the market is very expensive

The “equity risk premium” [(stock earnings / price) – (10-yr Treasury yield)] is the only key valuation metric that suggest that stocks may not be overvalued; and that argument depends of the current historically low Treasury yields.

FIGURE 10:

Current equity risk premium for the 10-year inflation adjusted earnings-to-S&P 500 price is 0.90%. Since 1881, the equity risk premium for the S&P 500 and its large-cap precursors was higher 68% of the time.  That suggest modest overvaluation.

However, since the risk premium first went negative in 1964 (except for 4 months in 1929), the equity risk premium was only higher than now 30% of the time — a Bullish suggestion.

The question is whether the 135 history, or the 52 year history is the more important to consider. If the long history is more important, then the S&P 500 is somewhat expensive relative to the yield on 10-year Treasuries; but if the shorter history is more important, then the S&P 500 is inexpensive relative to Treasury yields.  However, Treasury yields are suppressed, and if they normalize to something in the 3% to 4% range before profits increase a lot, then stocks are expensive.
2017-03-13_09
FIGURE 11:
Current equity risk premium for the 12-month trailing earnings-to-S&P 500 price is 1.17%. Since 1881, the equity risk premium for the S&P 500 and its large-cap precursors was higher 68% of the time.  This also suggests moderate overvaluation.

However, since that risk premium first went negative in 1967 (except for 1 month in 1921), the equity risk premium was only higher than now 29% of the time — a Bullish indication.

The question is whether the 135 history, or the 49 year history is the more important to consider. The same logic applies as it does for the equity risk premium based on the 10-year inflation adjusted earnings yield.
2017-03-13_10
FIGURE 12:

S&P 500 GAAP earnings are not much higher than they were 4 years ago, yet the price of the index is a lot higher. That means much of the rise in the price of the index is merely paying more the what you get, not getting proportionately more for paying more.

10-year Treasury rates in 2013 more than doubled from less than 1.5% to more than 3%, yet the S&P 500 continued to rise in price faster than earnings.

Once again 10-year Treasuries have risen in 2016 from less than 1.5% to more than 2.5% and the price of the S&P 500 has continued to rise, even in the face of flat earnings, with falling earnings close behind in the rear view mirror.

If interest rates should make it to 3% in the near-term (not an unthinkable event), the equity risk premium on trailing 12-month earnings would drop from 1.17% to about 0.75%. Since 1881, the risk premium has been higher than 0.75% more than 70% of the time; and since 1967 it has been higher 64% of the time.  That would be Bearish.

This suggests valuation vulnerability in the face of probable moderate interest rate increases.

2017-03-13_11
SENTIMENT

FIGURE 13
The State Street Investors Confidence index is a behaviorally measured sentiment index — a measure of increases or decreases in public equity allocation in actual institutionally managed portfolios, a real measure of market sentiment by large institutions.

The rate of increase in their public equity risk allocations began a decline in around 2 years ago.  They began actually decreasing their public equity allocations in 2016 and continue to do so.

This is not an endorsement of current stocks markets.
2017-03-13_12
FIGURE 14:
Investors Intelligence monitors 100 leading investment newsletters to gauge the Bullish or Bearish sentiment of those writers. Extreme peaks in sentiment tend to be contrary indicators (not perfectly, of course), but when “everybody” is Bullish or Bearish, a trend is often about to be exhausted; because there are few additional people to join the point of view and bring move more money in the direction of the trend.

The current Bull-Bear spread is among the most extreme Bullishness of the last 10 years.  This suggests that a corrective action is likely nearby.

2017-03-13_13
FIGURE 15:
The American Association of Individual Investors conducts a continuous online survey of it members — essentially the retail investor.  Last week when this chart was created, the Bull-Bear spread was 2.29%, barely on the Bullish side of neutral.  In the subsequent week it turned on a dime dropping to negative 16.5%; strongly Bearish.

The chart suggests that this data is more a coincident indicators than a forward indicator, so the drop in sentiment parallels the recent weakness in the up trend.
2017-03-13_14
FIGURE 16:
TD Ameritrade publishes the Investor Movement Index.  It is Bullish at this time.  Here is what they do to make their index.

Each month Ameritrade calculates a short-term Beta (volatility relative to a benchmark such as the S&P 500) for each security.
Then it takes a sample of hundreds of thousands of customer accounts with at least $2,000 in their account and in which at least 1 trade was done the month, from its approximate 6 million customers.
It measures the total equity allocation and the aggregate short-term Beta (volatility relative to volatility of the S&P 500) of the equities in each portfolio (and other undisclosed factors) to develop the risk level of each portfolio.
Then equal weighting each account without regard to size or number of trades, it finds the median equity risk exposure, and puts that on its index scale (scale parameters not disclosed), and plots that versus the S&P 500.
The level and direction of the index is an indication of actual retail investor behavior instead of what they might say about their sentiment.

2017-03-13_15
FIGURE 17:
The options market reveals the actual risk taking behavior of investors in terms of the pursuit of gain (buying CALLs) or seeking protections (buying PUTs).  Here are 4 measures of options market behavior.

VIX measures the expected volatility of the S&P 500 over the next 30 days.  At under 12, the VIX is well below the 10 year average of about 20, and among the lowest levels of the past 10 years.  This is complacency.  Complacency is probably like everybody being on the same side of a boat, which makes the boat prone to tip over.  Volatility is a mean reverting measure, which suggest more volatility in the relatively near future than in the relatively near past.

The SKEW Index (defined above in the jargon section) is a measure of the concern over the size and probability of an unusually large downside move.  That measure is elevated, which gives reason for caution.

The Equity PUT/CALL index (defined above in the jargon section) is a measure of the relative “protection seeking/opportunity seeking” behavior of mostly retail investors.  That ratio is slightly elevated versus average levels, indicating a mildly increased relative pursuit of protection.

The Index PUT/CALL index (defined above in the jargon section) is a measure of the of the relative “protection seeking/opportunity seeking” behavior of mostly institutional investors.  That ratio is slightly lower than average, indicating a mildly lower than average relative pursuit of protection.
2017-03-13_16
BREADTH
This is one of our favorite measures, and one that we directly measure weekly since the beginning of 2014.  Breadth measures the condition or behavior of the overall membership of the broad S&P 1500 index and compares it to the price level of the market-cap weighted S&P 500 index — in other words, it checks to see if the rank and file members of the market are going in the same direction as the mega-cap leaders of the market.

For example, the price movement of Apple and Exxon have a lot more impact of the price of the S&P 500 or the S&P 1500 than 100’s of smaller members of the S&P 500 and S&P 1500.  If the rank and file are going in the same direction as the leadership, that is Bullish breadth.  If they are going in the opposite direction, that is Bearish breadth.  The leaders can only go so far for so long without the rank and file coming along.

FIGURE 18:
The percentage of S&P 1500 index constituents in a Correction or worse (grey line — down 10% or more from their 12-month high) rose dramatically before the November presidential election, then dropped off just as steeply to among the lowest levels in the past 3 years.  Just recently, however, the percentage in Correction or worse sharply turned up — still in “normal” range, but the direction change is a negative for the current stocks rally.

The same is true, but to a lesser extent for the percentage of S&P 1500 stocks in a Bear or worse (blue line — down 20% or more), or in a severe Bear or worse (red line — down 30% or more).
2017-03-13_17
FIGURE 19:
The percentage of S&P 1500 stocks within 2% of their 12-month high was declining prior to the election, turned up sharply to reach the highest level in the past 3 years immediately after the election, but has since declined to the “normal” range with a current downward direction.  The provides a note of caution about the current rally.
2017-03-13_18
FIGURE 20:
The Net Buying Pressure (Buying Pressure / Sum (Buying Pressure + Selling Pressure), which has been net positive since the bottom of the early 2016 Correction, began to decline before the election; resumed growing strength after the election; but has recently been losing steam.  This is not supportive of the current rally.
2017-03-13_19

BuyingPressureMethod
FIGURE 21:

The separate Buying Pressure and Selling Pressure components of the S&P 1500 stocks Net Buying Pressure in the figure above are shown here.

The rising S&P 500 price in 2016 was not matched by rising Buying or Selling Pressure, showing waning enthusiasm for equities.  After the election both Buying and Selling Pressure rose, but Buying Pressure rose more than Selling Pressure.  Recently however, the decline in Net Buying Pressure noted above, is the result of Buying Pressure declining substantially, while Selling Pressure has declined far less.

These data also suggest the fuel of the rally may be running low.
2017-03-13_20

PressureCompnentsMethod
FORECASTS
Looking way down the road with 5-10 year forecasts, and supporting our view that a shift in allocation more toward international equities, and less in US equities is appropriate, are forecasts by Research Affiliates (a noted factor-based asset manager), by GMO ( a Bearish asset manager for the very wealthy — $10 million and up to invest in their funds); and by BlackRock (the largest fund manager in the world).
FIGURE 22:
Research affiliates studies factors with focus on the current Shiller CAPE Ratio (Price divided by the inflation adjusted 10-year average Earnings) relative to its historical median, and historical highs and lows.  They find that to be a good long-term indicator of opportunity.  They view the CAPE Ratio as mean reverting over the long-term.

Based on CAPE and other factors, this chart shows how they see the real (nominal less inflation) return and the volatility of US, non-US Developed Markets (“EAFE”) and Emerging Markets (“EM”) working out over the next 10 years on an annualized basis.  They definitely see international equities as the place to be — but with more volatility.

2017-03-13_21
FIGURE 23:
GMO does not disclose their forecasting methodology, but they are among the most Bearish institutional manager, so worth noting for that.  Over the next 7 years, they see the real return on US large-cap stocks as negative 3+%; the real return on large international stocks as barely positive; and the real return on Emerging Market as positive 4+%.  They also see negative real returns on US and Dollar hedged international bonds, but positive 1+% real returns on Emerging Markets debt.

2017-03-13_22
FIGURE 24:
Over the next 5 years, BlackRock sees nominal return on US stocks as very low, and much lower than international stocks.  They see non-US Developed Markets stocks as generating nominal return  at about the same level as Emerging Markets, but with volatility similar to that of US small-cap stocks; whereas they see much higher volatility for Emerging Market stocks.
2017-03-13_23

 

 

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Target Date Funds As Aid In Retirement Portfolio Design

Sunday, October 4th, 2015
  • Investors in or near retirement should be aware of portfolio design leading fund sponsors suggest as appropriate
  • Leading target date funds appear to generally have less severe worst drawdowns than a US 60/40 balanced fund
  • The funds have slightly higher yields than a US 60/40 balanced fund
  • Target date funds have underperformed a US 60/40 balanced fund in part due to a cash reserve component and non-US stocks
  • Non-US stocks drag on historical performance could become future boost to performance.

INTENDED AUDIENCE

This article is suitable for investors who are in retirement or nearly so, and who are or will rely heavily on their portfolio to support lifestyle.

It is not suitable for those with many years to retirement, or those with a lot more money in their portfolio than they will need to support their lifestyle.

SHORT-TERM and LONG-TERM

We have been writing about the short-term recently (here and here and here), because we are in a Correction, that may become a severe Correction, and possibly a Bear.

For our clients who fit the profile of being in or near retirement and heavily dependent of their portfolio to support lifestyle in retirement, we have tactically increased cash in the build-up to and within this Correction, as breadth and other technical have deteriorated.

However, we don’t want to lose sight of long-term strategic investment.  This article is about asset allocation for investors that fit that retirement, pre-retirement, portfolio dependence profile.

WHERE TO BEGIN ALLOCATION THINKING

We think it is a good idea to begin thinking about allocation by:

  1. reviewing the history of simple risk levels (see our homepage) from very conservative to very aggressive to get a sense of where you would have been comfortable
  2. reviewing what respected teams of professionals at leading fund families believe is appropriate based on years to retirement (they assume generic investor without differentiated circumstances).

This article is about the second of those two important review — basically looking at what are called “target date” funds.

Generally, portfolios should have a long-term strategic core, and may have an additional tactical component.  We think some combination of risk level portfolio selection and/or target date portfolio selection can make a suitable portfolio for many investors.

You may or may not want to follow target date allocations, but you would be well advised to be aware of the portfolio models as you develop your own.

In effect, we would suggest using risk level models and target date models as a starting point from which you may decide to build and deviate according to your needs and preferences, but with the assumption that the target date  models are based on informed attempts at long-term balance of return and risk appropriate for each stage of financial life.

For example, an investor might deviate one way or the other from more aggressive to less aggressive based on the size of their portfolio relative to what they need to support their lifestyle, and the size of non-portfolio related income sources; or merely their emotional comfort level with portfolio volatility.

There no precise allocation that is certain to be best, which is revealed by the variation in models among leading target date fund sponsors.  Their allocations are different, but similar in most respects.

FUND FAMILY SELECTION

For this article, we identified the 7 fund families with high Morningstar analyst ratings for future performance (those ranked Gold and Silver, excluding those ranked Bronze, Neutral or Not Rated).

Those 7 families are:

  • Fidelity
  • Vanguard
  • T. Rowe Price
  • American Funds
  • Black Rock
  • JP Morgan
  • MFS

Fidelity, Vanguard and T. Rowe Price have about 75% of the assets in all target date funds from all sponsoring families combined.

ASSET CATEGORIES CONSIDERED

We then used Morningstar’s consolidated summary of their detailed holdings to present and compare the target date funds from each family.  The holdings were summarized into:

  • Net Cash
  • Net US Stocks
  • Net Non-US Stocks
  • Net Bonds
  • Other

While we have gathered that data for retirement target dates out 30 years.  This article is just about target date funds for those now in retirement or within 5 years of retirement.

PROXY INVESTMENT FUNDS USED

We simulated the hypothetical past performance of those target date funds using these Vanguard funds:

  • VMMXX (money market)
  • VTSAX (total US stocks)
  • VGSTX (total non-US stocks)
  • VBLTX (aggregate US bonds)

Admittedly, this is a gross proxy summary of the holdings of the subject target date funds  The funds may hold individual stocks or bonds, may hold international bonds, may use some derivatives, and may have some short cash or short equities. Nonetheless, we think these Vanguard funds are good enough to serve as a proxy for the average target date funds, and as a baseline model for you to examine target date funds and to plan your own allocation.

THE BENCHMARK

As a benchmark for each allocation, we chose the Vanguard Balanced fund which is 60% US stocks/40% US bonds index fund. Figure 1 shows the best and worst periods over the last 10 years for that fund, as well as its current trailing yield.

FIGURE 1:

20151004_Balanced

So, let’s keep the 2.10% yield in mind as we look at the models, and also the 19.7% 3-month worst drawdown, the 27.6% worst annual drawdown, and 7.3% worst 3-year drawdown.

FOR THOSE CURRENTLY RETIRED

Figure 2 shows the allocation from each of the fund families for those currently in retirement.  It also averages their allocations for all 7 and for the top three (Fidelity, Vanguard, T. Rowe Price).

(click image to enlarge)

2015_Funds

You will note substantial ranges for allocations from fund family to fund family.  For example, MFS using about 19% US stocks while Fidelity uses about 38%; and MFS uses about 64% bonds and Fidelity uses about 36%.

The average bond allocation for the 7 families is about 54%, but the top three by assets average about 42%; and their average cash allocation is about 9% versus the top 3 average of 5%.

Figure 3 shows how a portfolio using Vanguard index funds would have performed over the past 10 years with monthly rebalancing if it was based on the average of the top 3 families.

We recalculated the allocations to exclude “Other” which is undefined, but which is relatively minor in size in each fund.

We also note that the Vanguard index funds have a small cash component, so that the effective cash allocation is higher than the model.

FIGURE 3 – Backtest Performance:
(retired now: average of top 3 families)

20151004_2015Av3

Observations: 

  • Yield is somewhat higher (2.28% versus 2.10%).
  • Worst 3 months were somewhat better (-18.4% versus – 19.7%)
  • Worst 1 year was somewhat better (-26.2% versus -27.6%)
  • Worst 3 year drawdown was better (-5.7% versus -7.3%)
  • Underperformed benchmark over 10, 5, 3 and 1 year and 3 months (10 years underperformed by annualized 1.05%).

Reasons For Underperformance:

Inclusion of non-US equities may be the biggest contributor to underperformance versus the balanced fund with 100% US securities.

Another part of the underperformance is maintenance of a cash reserve position that is over and above any cash position within the benchmark balanced fund.  Part is also  due to a higher bond allocation.

Those factors probably account most of the performance difference.  We did not try to determine the exact contributions of each attribute to performance differences.

The historical underperformance due to non-US stocks could possibly turn out to be a long-term reason for future outperformance.

FIGURE 4 – Backtest Performance:
(retired now: average of top 7 families)

20151004_2015Av7Observations: 

  • Yield is somewhat higher (2.19% versus 2.10%).
  • Worst 3 months were significantly better (-12.6% versus – 19.7%)
  • Worst 1 year was somewhat better (-17.7% versus -27.6%)
  • Worst 3 year drawdown was a lot better (-2.3% versus -7.3%)
  • Underperformed benchmark over 10, 5, 3 and 1 year & outperformed over the last 3 months (10 years underperformed by annualized 1.32%).
  • Incurred less drawdown in exchange for lower cumulative return.

FOR THOSE EXPECTING TO RETIRE WITHIN 5 YEARS

FIGURE 5 – Allocation:
(expected retirement within 5 years)

(click image to enlarge)

2020_Funds

Again, we see substantial variation between fund families, and also between the averages for the top 3 by assets and for all 7 of the Gold or Silver rated target date families.

The average bond allocation for the 7 families is about 44%, but for the top 3 it is only about 34%.  For the 7 families the average non-US stocks are about 15%, but for the top 3 families it is about 21%.

FIGURE 6 – Backtest Performance:
(up to 5 years to retirement: average of top 3 families)

20151004_2020Av3Observations: 

  • Yield is higher (2.30% versus 2.10%).
  • Worst 3 months were somewhat worse (-21.1% versus – 19.7%)
  • Worst 1 year was somewhat worse (-30.1% versus -27.6%)
  • Worst 3 year drawdown was the same (-7.3% versus -7.3%)
  • Underperformed benchmark over 10, 5, 3 and 1 year and 3 months (10 years underperformed by annualized 0.95%).

FIGURE 7 – BacktestPerformance:
(up to 5 years to retirement: average of top 7 families)

20151004_2020Av7Observations: 

  • Yield is somewhat higher (2.19% versus 2.10%).
  • Worst 3 months were better (-16.2% versus – 19.7%)
  • Worst 1 year was better (-22.9% versus -27.6%)
  • Worst 3 year drawdown was better (-4.4% versus -7.3%)
  • Underperformed benchmark over 10, 5, 3 and 1 year & slightly outperformed over the last 3 months (10 years underperformed by annualized 1.19%).

PERFORMANCE OF INDIVIDUAL PROXY FUNDS

Figure 8 presents the current yield and rolling returns of the five individual proxy funds used in this review.

FIGURE 8:

(click image to enlarge)

20151004_proxyfdreturns
PERFORMANCE OF THE TARGET DATE FUNDS

FIGURE 9:

(click image to enlarge)

20151004_TgtDateFunds

Symbols for funds mentioned in this article are: VMMXX, VTSAX, VGTSX, VBTLX, VBIAX, TRRGX, AABTX, JSFSX, LFTDX, VTXVX, FLIFX, BAPBX, TRRUX, AACFX, JTTAX, MFLAX, VTWNX, FPIFX, BAPCX

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Retirement Balanced Portfolio: Asset Super Class Performance From 1928

Monday, June 29th, 2015

Allocation all boils down to Owning, Loaning and Reserving.  Everything else is a variation on implementation of these three super classes.

Retirement portfolios need some Owning (for capital and income growth), some Loaning (for steady income and portfolio volatility dampening), and some Reserving (for dependable cash availability for withdrawals, and less reason to panic when the market is panicking).

The term “asset class” gets tossed around a lot and sometimes asset types that are merely subcategories of true asset classes are mislabeled as “asset classes”.  While the use of the term is certainly arguable, the three most basic asset classes are: (1) cash reserves, (2) loans made to others, and (3) ownership of something like stocks, real estate or commodities.  We think of them as “super classes”, because just about everything else falls under one of these as a subcategory (even derivatives).

LOR_ThreePrimarySuperClasses

Three specific examples of Loan, Own and Reserve are the 10-Year Treasury Bonds (Loan), the S&P 500 (Own) and 90-day Treasury Bills (Reserve).

They, like the super classes to which they belong, are substantially minimally or even negatively correlated over reasonable periods of time.

While stocks and bonds have periods of high correlation, such as in panics, where there may be a rush to cash for safety and liquidity; for the most part they react differently to different circumstances, making them good pairs, along with cash reserves in a portfolio where risk (volatility) control is an important goal.

For most asset categories really long-term data is hard to find, but for 10-year US bonds, US large-caps stocks (S&P 500 and precursors), and 90-day T-Bills; we have data back to 1928 as proxies for the Loan, Own and Reserve super classes.

Let’s see how those super classes behaved in total return, price return and income return in an annually rebalanced tax-deferred or non-taxable account from 1928 through 2014.

The portfolio we use here is 60% US large-cap stocks, 31% 10-year Treasury Bonds, and 9% of 90-day T-Bills. US large-cap stocks are the S&P500 and its precursors.

That is a specific modification of a generalized 60/40 portfolio to make room for a three bucket (9%) operating reserve for retirement accounts.  The reserve is important to create fairly high certainty of capital available for withdrawal for up to 3 years, which is helpful to avoid panic in a steep down stock or bond market.

There are very few periods where a balanced portfolio is down for more than 3 years, so the 9% 3-bucket reserve can help a retiree glide over a bear market without selling assets at fire sale prices to fund living expenses.  Selling assets at depressed prices in retirement is a good way to outlive your assets — and that is not a good thing.

In practice, the 60% in stocks would likely include different market-cap sizes, and some international in most cases; and the 31% in bonds would likely include different durations and perhaps qualities, and maybe some international; and the 9% in reserves (90-day T-Bills as proxy here) would probably consist of 3% in a money market fund (duration about 90 days),  3% in an ultra-short bond fund (duration about 1 year) and a short-term bond fund (duration about 2.5 to 3 years).

Figure 1 is a chart showing the annual total return of the 60/31/9 portfolio from 1928 (87 years), along with the three-year moving average of total return:

Figure 1: Total Return – 60 stock / 31 bonds / 9 reserve

60-31-9 total return

There were some substantial dips on an annual basis, but the 3-year average was almost always positive, and where negative was mostly only mildly so.  Except for the Great Depression where the 60/31/9 declined over 14%, the worst decline was less than 4.5%

There were only 7 years of the 3-year average that were negative, and only two periods had back-to-back negative years: 1931-1932 and 1941-1942.  Two of the 7 down years had declines of less than 0.5%.

Specifically for individual years, there were 19 out of 87 years with a negative return (21.84%) of the time.

The periods of back-to-back negative periods were:

  • 4 years from 1929-1932
  • 2 years from 1940-1941
  • 2 years from 1973-194
  • 2 years from 2001-2002

The traditional 60/40 fund uses the S&P 500 index and the Aggregate Bond index.  That fund had total return less than negative 22% in 2008 (ref: Vanguard Balanced Fund VBIAX), whereas this 60/31/9 portfolio illustration uses Treasury debt for both the 31 and the 9.  Since 2008 was a year of panic, Treasury debt outperformed Aggregate Bonds.  This example portfolio declined 15.56% in 2008.

Both VBIAX and this example portfolio declined more than 22% and 15% from their intra-year 2007 peak to their 2008 intra-year bottom, but this memo is only about calendar year performance.

Figure 2 is a chart showing the price return separate from the income return for the 61/31/9 allocation.

Figure 2: Price Return and Income Return – 60 stock / 31 bonds / 9 reserve

61-31-9 price and income return separately

As you might expect the income return is far less volatile and more reliable than the price return.  That is important to retirees who are drawing on their portfolios.

The brown line is the price return and the green line is the income return.  The dashed black line is the 4% return level that relates to the 4% rule of thumb for retirement withdrawals.

While total return had 19 negative years of 87, price return had 29  (33.33% of the time).  It was the income return that saved the portfolio from the 10 extra negative years.

The specific back-to-back negative price return periods were:

  • 4 years from 1929-1932
  • 3 years from 1939-1941
  • 3 years from 1946-1948
  • 2 years from 1973-1974
  • 2 years from 1977-1978
  • 3 years from 2000-2002

With regard to the 9% 3-bucket reserve, individual bonds are probably not a practical alternative for most retirees for a variety of reasons. Here are three low-cost Vanguard funds that could probably fulfill the objectives and uses of the 9% reserve.

9 pct reserve bucket

 

 

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