A
Logical Approach to Portfolio
Construction
John Riley,
Chief Strategist
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If you are like most
people, the architects of your portfolio have been ad hoc, chance
and spur-of-the-moment. We see portfolios all the time from investors
that have no idea why they have the investments that are in their
portfolio. It was what was available, a friend said to do it or I
didn’t know what else to do are common responses.
Cornerstone takes a different
approach in building a portfolio. Our perspective is Top-down, which
means we look at the overall economic conditions and markets first,
and pick the actual investments last.
With all of the different
investment options available today – Large Cap, foreign debt, emerging
markets, junk bonds, small cap… the list goes on – how does an investor
make a decision about where to invest? There are so many options,
it gets confusing.
We start simply, by asking ourselves
questions. We build the portfolio by first looking at long term trends,
then intermediate trends and last short term.
What are the overall
long term trends?
 The
US stock market – With
the potential for earnings disappointments and a slowing economy,
the long term trend (several years) for the stock market is down.
It will likely be held back by the still unfolding housing collapse,
a retreat of consumers and rising unemployment. This should impact
earnings negatively and send the market to levels not seen in a decade.
Strategy
– Avoid US equities, sell into rallies. Invest in “bear market” funds
or market hedges, such as several of the ETFs available that invest
in the short side. This gives us our first piece of the asset allocation
pie: Market Hedges
Inflation – What
is the current environment? Are prices for goods and services rising
or falling? This can be confusing sometimes because both can be happening
at once. On the one hand, the cost of raw materials and labor costs
are rising for the major auto manufacturers, but at the same time,
foreign competition is forcing prices to the consumer down, squeezing
the profits of the car manufacturer.
 Inflation
in raw materials is a function of foreign consumption. This is a trend
that is not likely to slow down any time soon. They have tasted capitalism
and they like it. Millions of people will be migrating from rural
areas in the 3rd world to more urban areas and along with that comes
an almost geometric increase in the consumption of raw materials.
Strategy – The
obvious answer is commodities and natural resources companies, especially
oil. At various times the shift within the sector will go from food
to base metals to industrial materials to oil and so on. But in general,
this group has the biggest bullish push on it of any sector, with
an expected bull market run that could last years if not decades.
Investing in natural resources, commodities and raw material companies
is the next piece of the pie.
 Lower
interest rates – This is an interesting one. Lower short
term interest rates does not mean lower long term interest rates.
In fact, low short term interest rates does not mean a healthy economy.
Interest rates in the 1930’s were at or near zero and the economy
was still depressed. In Japan for the past 15 years, they have been
going through a deflationary funk that interest rates at zero percent
could not fix.
Why are low interest
rates likely not to help the economy? Because of too much debt. Almost
every sector of the economy, from the government to the consumer is
loaded down with record debt levels.
Strategy - As
the Fed cranks up the presses to print more Dollars, the US Dollar
is diluted and devalued. The best way to hedge the declining Dollar
is to own the opposite asset. Foreign Debt and Gold.
 Growing
Trade Deficit – With the potential for declining earnings
domestically and the continual growth of the trade deficit, foreign
companies may pick up the slack for growth. Opportunities may be presenting
themselves for foreign companies to do more business with each other
as America’s share of the Global GDP continues to shrink.
Strategy – Owning
International Equities may be a better source of equity growth compared
to US stocks for the next several years.
 Geo-Political
Tensions – With the world the way it is today, war in the
Middle East, hot spots in Asia and growing tensions in South America,
a surprise, war or terrorism should be expected.
Strategy – Have
some assets as a safe haven is important. Cash is king for this when
it comes to principal safety and Treasuries are a place money runs
to when there is global trouble. Since we are concerned with inflation,
TIPs (Treasury Inflation Protection Securities) fill the bill here.
Momentum –
The boys on Wall Street still control the game. They have defied the
odds for years. The market should have had a correction years ago.
The rally within a bear market that started in 2003 has gone on for
much longer than most expected.
Strategy – Humility
is important. No matter how right the evidence and statistics are,
momentum can still carry the market higher in the face of terrible
news. Having a balanced fund in the portfolio gives the investor a
piece of what the boys on Wall street are doing.
 Market
Rallies – Regardless of the market conditions, even in the
worst bear markets, there are always rallies. And many of them are
tradable rallies. In most cases, investors should sell into rallies.
But once the asset allocation is set, investors can take advantage
of the rallies.
Strategy – Be prepared
to trade. Not day trade, but take advantage of mis-priced securities,
whatever they may be, whether they are stocks, bonds or whatever.
Allocation
Now that we have the assets picked, next
is the allocation part. This is determined by how much risk the
investor is willing to accept and how much of an impact the asset
class is likely to have.
We are constantly adjusting
the allocation of the portfolio to take advantage of the shifting
sands of the market place and economy. We look at intermediate and
short term trends when adjusting our allocation.
What are the intermediate
trends? These could be an acceleration of the long term trend or counter
trends to the long term. If an asset class has gone too far too fast,
we may reduce our allocation in anticipation of a pullback. For instance,
if oil were to race up to 120/bbl in the next 2 weeks based on tensions
in the Middle East, we would be ready to cut our Natural Resources
allocation. We would then increase it after a significant Pullback.
Short term opportunities
could include trades and taking advantage of anticipated news. If
it were expected that more banks were going to report huge losses
due to sub-prime, we might increase our hedges specifically in the
financial area. Or if some bad news came out for a stock that had
been a consistent performer, and the stock dropped quickly, we might
use that as an opportunity to trade.
Our strategy is fully
flexible. In other words, if it appeared that the US market had become
a good value
again, we would adjust our asset allocation to include that asset
class. We are not locked into a certain predetermined minimum or maximum
percentage on any asset class.
Our Asset Allocation
is also not static. It needs constant monitoring and adjusting. In
the current and foreseeable market and economic conditions, the old
buy n’ hold mentality of the 90’s will not work.
If this logical approach
to portfolio construction is something you agree with, then Cornerstone’s
money management may be for you. Contact our office or your local
Cornerstone rep for more information on how you too can have this
kind of investment strategy.
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