A
Logical Approach to Portfolio Construction
John Riley, Chief Strategist
Feb 15, 2008
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 pre-determined
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.
|
