October 20, 2014

Main points:

  • We use the current market volatility to makes some adjustments to our recommended asset allocation.
  • We modestly reduce our pro-cyclical bias by lowering the allocation to equities.
  • To offset this reduction, we recommend adding to liquid alternative ETFs, which following their recent sell-off, have become all the more attractive.
  • We believe that the longer-term investment case for equities remains intact, but that investors should tilt equity exposure to US markets.

 

While geopolitical risks, and the threat of the Ebola virus, remain in the background, we believe the selloff is primarily attributable to a sharp downward adjustment in expectations of global growth.

Market sell-offs like this are not unprecedented – indeed this is the fourteenth greater-than-5% sell-off in the S&P500 since the rally began in 2009. There have been two 10% sell-offs. Yet, what is different about this sell off is that it is coming from a higher level of valuations, potentially giving rise to increased market anxiety around individual announcements of economic data.

We remain confident that US economic growth will continue, in spite of Wednesday’s data, and expect real GDP growth of around 3% in 2015. This should trans-late into solid earnings growth, which will act as a solid foundation for further gains in the market this year.

Among the notable features of the most recent sell-off has been the sharp reaction in government bond markets. This should have helped cushion diversified portfolios somewhat against equity market declines. The US 10-year government yield briefly fell through 2%, indicating market expectations that the likes of the Federal Reserve could shift to a more dovish stance in the coming months.

Our overweight positioning is now concentrated in US – the region of the world with the most positive economic growth – and we are overweight both US equities and US high yield bonds. We also remain overweight the US dollar relative to the euro: even if the Fed adopts a more dovish stance it is still likely to increase rates significantly earlier than the ECB.

From here we expect some stabilizing factors to help further boost US growth. First, the decline in mortgage rates will likely support housing activity. Second, the decline in energy prices has fed through into gasoline prices which are now at the lowest level since early 2011. This should support consumption. Finally, should inflation or growth surprise to the downside we expect the Fed to remain accomodative.

The market environment of low volatility and low yields in recent years may have led some investors into taking greater levels of risk than they should in order to generate higher investment returns. This, the largest increase in market volatility in more than two years, should be used as an opportunity to understand whether portfolios have suitable levels of risk.

We encourage investors to take advantage of our expertise in evaluating portfolios quickly, accurately, and inexpensively through our Portfolio 2nd Opinion service. Send your inquiries to us at info@zeninvestor.org

About the author 

Erik Conley

Former head of equity trading, Northern Trust Bank, Chicago. Teacher, trainer, mentor, market historian, and perpetual student of all things related to the stock market and excellence in investing.

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