Going Into 2010 Locked and Loaded

It may be boring, but end of year rebalancing is a good time to take stock of your current assets and position yourself for the coming year. Based on my risk profile and age, my strategic asset allocation is the following:

Stocks
Domestic Large Cap 30%
Domestic Small Cap 10%
International Large Cap 10%
International Small Cap 5%
Bonds
Domestic Short-Term Duration 5%
Domestic Intermediate-Term Duration 10%
International Short-Term Duration 5%
International Intermediate-Term Duration 5%
Commodities 5%
Cash 15%

There are many other assets that people may consider, from managed future contracts to hedge funds, private equity and even real estate. However, the ones I've chosen are the essential assets every middle-class investor should own to provide maximum diversification (or simply the best bang for your buck).

For the past two weeks, I've been optimizing my domestic equity holdings, which numbered more than a dozen active mutual funds. I've cut that number in half, while maintaining diversity in everything from stock holdings to the management company itself. (You don't want one company, say Vanguard, managing all your assets because they rely on the same research for all of their funds, you want maximum diversity in research and thought leadership.) Out of full and fair disclosure, here are my U.S. stock funds:

Large Cap

• American Funds Growth Fund of America (AGTHX) - Hardly a better active fund out there.
• Fidelity Balanced Fund (FBALX) - A solid performing conservative large-cap blend fund with some fixed-income holdings.
  
• AIM Diversified Dividend Fund (LCEIX) - A great value fund with large dividend component expected to do well as the market stabilizes.
• iShares S&P 500 Growth Index (IVW) - A passive growth index fund chosen for maximum short-term return (play on technology) with ease of entry and exit (highly liquid, no short-term trading penalties)

Small/Mid Cap

• Royce Small Cap Value Fund (RYVFX) - Like American Funds, a top-notch active small cap fund manager. You want active managers (not index funds) to oversee your small cap assets because these markets are much less efficient than large cap markets (not a lot of people looking at the small companies) and an active manager can exploit this.
• Scout Mid-Cap Fund (UMBMX) - This is a new fund for me, so we'll see how it does. Gives greater diversity when paired with a small cap fund like Royce. Has a good track record and is managed by a fellow CFA charterholder, which gives me confidence.
  

Consumers Aren't Playing Grinch This Christmas

Ho, Ho, Ho!
Early indicators are pointing toward another strong corporate earnings season for the ending fourth quarter of 2009. Contrary to fears, revenue growth is picking up steam. Don't count the consumer out yet, the Blizzard of 2009 notwithstanding.
As always, the question is: How much of this is already baked into stock prices?

Experts are predicting stronger than average GDP growth this quarter (3.7%) and preliminary estimates show that such rosy expectations may be justified. GDP forecasts indeed may be too low. Could we see a 4.4% GDP number?? A blowout quarter by the US economy would be welcome relief to many. However, the specter of higher interest rates would send stocks lower if GDP is overheating. The Federal Reserve would raise rates sooner to cool off the economy and protect against the threat of inflation.

At best, earnings match or slightly beat expectations and fourth quarter GDP (announced at the end of Janurary) comes in as forecast. No reason to suggest it won't. So stay invested and even overweight in stocks.

The next possible bump in the road will be the end of March when the Fed ceases making the market in mortgaged-backed securities (home loans). Will the private sector step in and take over? If not liquidity will dry up and the market will suffer. Stay posted.

Merry Christmas!

Is this guy reading my blog?

Another expert concurs with my prediction that stocks gain north of 15% by early next year as I described in my earlier post Time to Put Money to Work

Read his analysis here:

Market to rise another 15%-20% by mid 2010: Strategist

Deal Shows Stocks Remain Undervalued

Comcast and General Electric have just agreed to a deal for a joint stake in media giant NBC Universal, which is currently a unit of GE. They value NBC at $30 billion.

For some investors like myself, this represents another strong signal that the stock market remains highly undervalued. The reason is that this is a real-time valuation that puts the network at almost 2 times annual sales ($30 billion/~$15 billion annual sales), while the average media network today is selling at just over 1 times sales.

Why are these companies valuing NBC at twice the market? Either because NBC is twice as valuable as the average media network, including stalwarts like Time Warner and Disney, (this I doubt) or that the overall market is undervalued.

One of the greatest mutual fund managers of all time, Bill Miller, uses current deals like this and asset valuations from recent bankruptcy filings as a basis for valuation of all his holdings. His record attests to this process.

As I explained in my earlier post, Time to Put Money to Work, there remains significant upside to this market based upon its current valuation. The bottom line is that the stock market's value is whatever investors are willing to pay for it. And today, for GE and Comcast, that is a lot more than what it costs.

A Golden Opportunity??

Everyone is asking me about one thing these days: Should I buy Gold?

Telling people to buy gold now is like yelling "Fire!" after everyone has left the building.

I do own a small stake (5%) in the largest gold ETF in the world, GLD and I believe every investor should own some as a hedge against inflation and a hedge against overall uncertainty with global economic growth.

But I would not suggest buying gold to make a quick buck. Lately, Gold has become very closely correlated with the entire stock market. So if you want to speculate, buy stocks instead. At least there is a valuation basis to owning stock and you can earn dividend income in the meantime.

As I described in an earlier blog "Time to Put Money to Work" there is a strong valuation basis to owning the stock market today. Additionally, there is a heavy upward momentum bias driving stocks higher. TV pundits refer to this as the "Risk Trade" whereby the US dollar goes down and the stock market rises. While I'm not a firm believer in the basis for this argument, I can't deny its effect on the market. So, there you have it, valuation and momentum, you're entry signs to get heavy on equities - advice that is worth its weight in gold.

Tactical Asset Allocation Explained

By Dan Lowrey, CFA
Manager Woodshed Investments

If you're like most investors, you have a 401k or retirement account filled with a diversified array of mutual funds, likely selected by your financial adviser. You may also have one or two Exchange Traded Funds (ETFs) or maybe some hot stocks you are hoping to generate some "mad money."

You no doubt have suffered major investment losses since last year as your financial adviser didn't have the foresight, or better yet the incentive, to get you into cash before the market tumbled.

Face facts. Investment advisers don't get fees when your accounts are in cash. They get paid commissions to recommend mutual funds and they also get a percentage of assets invested. When was the last time a financial adviser told you: "Hey, I think we should park your assets in a low-yielding money-market account for a while" ? Moreover, the mutual fund managers making the macroeconomic decisions with you money don't have your back either. They want only to match or beat the performance of an equity or bond index. Few are willing to take decisive action to protect assets or deviate from a stated investment strategy.

Tactical asset allocation (TAA) is the wave of the future. Your adviser will tell you that it's nothing more than market timing, which studies have proven time and again cannot be done. They'll tell you strategic asset allocation and sticking with a buy and hold strategy is best. I say TAA is being done and those investment shops with the best and brightest such as Goldman Sachs are doing it quite well ($3 billion in profit last quarter).

What's driving the demand for TAA?

1. Investor discontent with their mutual fund managers'
fees and performance.
2. Investor discontent with Wall Street profitability
at taxpayers' expense
3. The proliferation of ETFs

ETFs allow for a quick and cost-efficient vehicle for tactical asset allocation. Investors don't have to worry about short-term trading penalties associated with mutual funds. There are lower trading commissions (no loads, management fees, etc.) and lower tax implications. And there is a huge and liquid market for these products. A highly diversified portfolio can be created with just these ETFs:

1. S&P 500 SPY
2. US Investment Grade Bonds AGG
3. Treasury Inflation Protected Securities TIP
4. Gold Bullion GLD
5. Europe, Asia, Far East Index EFA
6. Emerging Market Index EEM

Optimally 4% SPY, 4% AGG, 1% EFA, 35% TIP, 37% GLD, 20% EEM

However, in periods of extreme financial distress even once uncorrelated assets show high correlation. Thus, bonds offered no protection from collapsing equity markets. Everything except cash and Treasuries plummeted. Having a portfolio, or at least a portion of your portfolio invested in ETFs and committed to a tactical asset allocation strategy is your best hope to swiftly react to quick changes in the market environment.

Ask your financial adviser about tactical asset allocation and they'll probably try and sell you another "product." Next . . . Entry and Exit Signs.

Time to Put Money to Work

By Dan Lowrey, CFA
Manager Woodshed Investments

I'm still bearish on analysts' estimates for corporate earnings next year. I believe they are too high. But even still, my estimate for corporate earnings next year ~ $67 for the S&P 500, based on current labor productivity, puts the forward operating P/E ratio for the index at 16, below the historical mean of 19.

With expected additional fiscal stimulus and a very gradual reversal in the unemployment rate, I'm forecasting the S&P to be around 1270 by early next year, almost 16% higher than today. My estimate is derived based upon the current civilian labor force, which today is about the same size as it was in 2004. Baring any unforseen shocks to the market, such as higher than expected unemployment, we should have operating earnings similar to that year, in my opinion.

Driving stocks further upwards, is most directly linked to accomodative monetary policies worldwide (cheap cost of funds with rates at almost zero here in the U.S.) Retail investors are still sitting on the sidelines. But the current pop in risky asset prices is being driven by investment banks and institutional managers. I forecast another strong quarter for investment banks as they seek to borrow for almost nothing and put this money to work in higher-performing equity and bond markets, especially those dominated in outperforming foreign currencies. Additionally, institutional investors (mutual funds) are chasing performance as the year draws to a close.

I'm recommending a 10%-15% over-weighting of the market account, with an emphasis on large cap equities and the technology sector in particular. (Note: This is a tactical asset allocation recommendation and short-term in nature. Strategic asset allocation decisions should be maintained in the long-run and apply to each individual's investment objectives and constraints. Consult your financial adviser for an appropriate strategic asset allocation.)

The Market Mattress Blog (Mission Statement and Purpose)

By Dan Lowrey, CFA
Manager Woodshed Investments

An opinionated, yet well-researched analysis of the current state of domestic economic activity and corresponding asset allocation recommendations. Or, how to best position your retirement accounts for their best risk-adjusted performance in the short-term. I suggest two basic accounts for every investor: A market account, which is invested in highly diversified mutual funds (both equity and fixed-income), and another that is invested in a highly liquid cash account.

I'm a finance professional, a CFA Charterholder and former financial journalist with Dow Jones Newswires. My motives are simply to provide free and unbiased financial advice to the general population to even the playing field with more sophisticated and better financed investors. I do this for fun and to keep a historical record of my investment analysis, recommendations and actions. I love to share with others equally passionate about investing.