Revised portfolio strategies
Letter from the President
We built a new short-term model portfolio to brace for the Fed rate hikes we expect next summer and adjusted our medium-term and long-term portfolios to reflect changes in our equity outlook: our view on U.S. energy stocks has darkened—we no longer can come up with a basis for anticipating a strong rebound in that sector for at least five years; more and more, we’re liking U.S. telecomm equity, for its attractive valuation and solid upward momentum.
One thing we are not changing is our strong tilt toward equity. Our neutral (core) equity allocation in our short-term portfolio is 0%, yet we’re taking a 10% position. For our medium-term portfolio, we define neutral as 40%, yet we’re holding 60%; for our long-term portfolio, while for us neutral is 60%, today we hold 70%.
We’ve built a new short-term model portfolio from scratch. Recall that this portfolio is designed to do no more than keep up with U.S. inflation. Its horizon is 6–24 months. Given our bullish view on equity, the dismal current and expected performance of high-yield U.S. bonds, and our view that emerging market inflation and thus rates are on a downward trend, our strategy for offsetting inflation is to hold small positions in U.S. large cap stocks and dollar-denominated emerging market sovereign bonds.
In preparation for Fed rate hikes, we’re no longer holding low-volatility U.S. equity. Because this segment is often sought out by income investors for its high dividend yield, it can exhibit bond-like behavior, falling in price or at least underperforming when interest rates rise.
Our currency diversification comes from a fund of broad investment grade non-U.S. stocks. In local-currency terms, they should perform well, as most of their host country central banks will be holding policy loose or loosening it further. But alas, their currencies will trend down against the dollar. We hold these bonds, then, solely as a hedge against the risk that our forecast for a strong dollar is overblown, and to moderate inter-day portfolio volatility.
We’ve invested the rest of this portfolio in quality: large positions in short-term U.S. municipal bonds and “cash” (1–12-month U.S. Treasury bills) and a small position in long-term (7–10-year) U.S. Treasury bonds.
Note how the term structure of the quality portion of this portfolio has “barbell” shape: it avoids the middle of the yield curve. The short end is the segment least vulnerable to rising rates. We expect the long end (in which our position is small) to fall sharply on trend but moderate day-to-day volatility and protect wealth (spike) should panic ever overtake the market.
We modified our medium-term (2–5-year) portfolio less dramatically. Although we held on to convertible bonds, we dumped U.S. corporate junk bonds, reduced exposure to 5–10-year investment grade bonds (corporates and Treasuries both), and opened a position in 7–10-year Treasuries.
We abandoned our overweight position in U.S. large-cap stocks by assigning equal weights across U.S. large, medium, and small cap stocks. This protects clients from the ups and downs of a handful of companies with huge weights in the S&P 500 index.
We kept in place our international diversification by holding on to our small positions in Asia-Pacific and developed Europe stocks. We continue to completely avoid emerging markets.
We keep overweight positions in our top favorite U.S. sectors: financials and, especially, real property. We closed our overweight position in U.S. energy stocks, as we no longer have a basis for forecasting recovery in this sector even for five years out. We closed our overweight on the U.S. materials sector in light of its current downward momentum and this portfolio’s investment horizon of just 2–5 years.
We made a single change in our long-term model portfolio: we closed our U.S. energy sector overweight and opened a new one in the U.S. telecomm sector, which we judge to be attractively valued and is exhibiting nice upward momentum. We maintain our small overweight positions in the U.S. financial and materials sectors and our larger one in U.S. real property.
We continue to hold as our core position a large holding of U.S. mid-cap value stocks.
We maintain our small satellite position in real estate mortgages despite our poor short-term outlook for this sector because we have a very positive view on this sector 5–10 years out and because of its low correlation with everything else in the portfolio.
We continue to focus our international equity exposure on developed Europe, Asia-Pacific stocks, and emerging markets. Within Europe, we still overweight Germany; within emerging markets, Mexico.
We still divide the fixed income portion of this portfolio between a large position in U.S. 5–10-year investment grade bonds and a small one in U.S. inflation-protected Treasury securities (TIPS).
Previous Letters from the President
2015–2016 Outlook: Low for Long (2015 01 17)
Still bullish on equity, happy with 7–10-year bonds (2015 01 08)
While we huddle, here’s my guest column on oil (2015 01 02)
Where the peso’s going and what to do (2014 12 15)
 Read descriptions of these portfolios here. Clients receive details on their composition in addition to individualized strategies and portfolio management services. To request more information, please write to firstname.lastname@example.org.