At Last. My Recommended Investment Asset Allocation.
My last post introduced you to my idea that debt growth is very important in determining how to best allocate your investment assets between stocks, bonds and cash. Based on my outlook for debt growth – and a few other variables – here is my current recommended asset allocation for the average investor:
How do I get there? I summarize my mechanics here, which are detailed in my book Debt Cycle Investing (I’ve conveniently linked you to my Amazon site, so nice of me).
My asset allocation mechanics.
This dashboard presents the key inputs to my asset allocation decision:
Sources: S&P 500 EPS – Yardeni Research. Debt growth and 10-year Treasury yield – Federal Reserve. S&P 500 price – Yahoo Finance. Inflation – Department of Labor. 1-year CD yield – Capital One ad.)
My stock market outlook
First off, note that my asset allocation is to investment classes, in this case the US stock market. No US vs. international call, no favorite sectors of the market, etc. I make the occasional stock call, like my current MGIC long and Wayfair short, but that’s a side business. My proxy for the US market is the S&P 500, which is roughly the 500 biggest public companies in the country.
Any stock analysis starts with earnings, or precisely the earnings per share (EPS) of the S&P 500. The $170.91 number shown in the dashboard is courtesy of Yardeni Research, which puts its estimate on the web. Yardeni estimates S&P 500 operating earnings (reported EPS less unusual income and expenses) over the next year.
The next item on our stock analysis agenda is annual private sector debt growth. As my last post said, it is a major driver of economic and profit growth. The 2.4% reading is the latest from the Federal Reserve, which means through the first quarter of 2018. As you can see, 2.4% growth is about normal. I do expect private sector debt growth to accelerate over the next year because lenders are currently seeing low default rates, and because financial regulation is being eased.
On to the price that investors are currently willing to pay for near-term EPS and the growth outlook. The S&P 500 index was 2840 at the close of trading last week.
Finally, my special sauce. In my book I show you a simple formula I use to take earnings, growth and price, as well as the level of interest rates, mash them up and spit out – not literally, that’s gross – a market risk factor. As this picture shows, the market risk factor gives a good indication of where the stock market is going over the next three years:
Sources: Yahoo Finance, S&P, Federal Reserve, Bureau of Economic Analysis)
The chart shows that the higher the risk factor – the more that investors are worried – the greater the stock market gains that are likely ahead. That makes common sense. As of today, the market risk factor of 5.4% is slightly below average, meaning that investors are fairly sanguine. Stock market returns over the next three years should therefore be below average, roughly in the 3-4% annual appreciation range. Not great, but not terrible.
My bond market outlook
As you’d expect, the stock market is more complicated than the bond market, so we’re through the hard stuff. My bond market proxy is the 10-year Treasury. Corporate and municipal bonds add some bells and whistles to the Treasury analysis, but not that many.
My 10-year Treasury bond analysis has just two factors – inflation and time value. I, and presumably you, want a bond yield that covers inflation, which is measured in my dashboard as the most recent year-over-year change in the CPI. If not, the purchasing power of your invested money declines. For example, if I earn 2% on a bond but the cost of sneakers rises 3% over the next year, I could afford the sneakers today but not in a year. So why not skip the investment and just buy the sneakers today? Only if my bond investment not only covers inflation, but gives me some extra; what I call the time value, or the holding period for the investment.
The dashboard shows that the historical average time value for a 10-year Treasury bond has been 2.5%. In other words, the average bond yield has been the current rate of inflation plus 2.5%. Today, the time value is only 0.2%. Why so low? And especially when the inflation rate has been rising? Two excellent questions I don’t have the space to address here, but the result is that bonds seem like a pretty poor investment at present, with losses on the value of the bond very possibly exceeding the yield on the bond.
My cash investment outlook.
For cash, I use the yield on a 1-year bank CD. Determining the current yield is surprisingly uncertain. Here are three measures:
- 0.4% - average rate paid today by all banks, according to Bankrate.
- 0.02% - the current offer on JPMorgan Chase’s web site. Yikes! Cheap bums.
- 2.4% - the current online offer from Capital One.
I’m assuming you’re smart enough to go for the Capital One rate. But the dashboard shows that even 2.4% is below the current 2.8% inflation rate, which means that cash has a -0.4% time value. Not good.
My asset allocation bottom line.
My investment model says that stocks should generate a below-average return, bonds a flat to negative return and cash not much better. What are we poor investors to do?
Make the best of a poor situation, that’s what. That’s what our Founding Fathers did. Asset allocation is about designing the best mix given the available choices. I therefore conclude that you:
- Avoid bonds. The current 3.0% 10-year bond yield isn’t close to compensating us for inflation risk and for tying up our money for a decade. I therefore lower my bond allocation from 35% normal to a measly 5%.
- Split the difference between stocks and cash. I move stocks from 55% normal to 70% and cash from 10% normal to 25%.
There you have it, people. Investment problems solved! More free time for binge watching.