Re­bal­ance away from US eq­ui­ties

Financial Mirror (Cyprus) - - FRONT PAGE - By Will Denyer

On Mon­day, the S&P 500 closed at a year-to-date high of 2,094, up 14.5% from its Fe­bru­ary 11 low. Now comes the real test of in­vestor con­fi­dence. At its cur­rent level, the in­dex is just 1.7% be­low its all-time high, set on May 21 last year. Since then, the mar­ket has tried and failed on four oc­ca­sions to sur­pass that level, in June and July, and then fol­low­ing the sum­mer’s sell-off, in Novem­ber and De­cem­ber. With the mar­ket ap­par­ently poised for yet an­other at­tempt, should in­vestors load up in an­tic­i­pa­tion of a break higher? Or should they take the op­por­tu­nity to sell out en­tirely?

Nei­ther. At this stage in the cy­cle, in­vestors should not be mak­ing dras­tic risk-on or risk-off bets, but should in­stead main­tain bal­anced port­fo­lios. As the in­dex dipped in Jan­uary, I rec­om­mended that in­vestors Keep Calm And Re­bal­ance Into Eq­ui­ties. To­day, the same bal­anced port­fo­lio ap­proach re­quires a par­tial shift out of eq­ui­ties, and into ei­ther cash, gold or bonds, all of which are all roughly flat since Fe­bru­ary.

Why a bal­anced port­fo­lio now? The an­swer is based on a frame­work I in­tro­duced late last year to as­sess where the US econ­omy is in its cy­cle, the chance of re­ces­sion, and the rel­a­tive at­trac­tive­ness of risk as­sets. It re­lies on the sim­ple ob­ser­va­tion made by Knut Wick­sell in 1898 that there is a nat­u­ral up­per limit to the in­ter­est rate that en­trepreneurs are will­ing and able to bear—and that rate is the ex­pected, mar­ginal re­turn on in­vested cap­i­tal.

If the cost of cap­i­tal rises above its ex­pected re­turn, en­trepreneurs will stop bor­row­ing to make new in­vest­ments. This will weigh on eco­nomic ac­tiv­ity (be­cause of less in­vest­ment and fewer hires), as well as on money sup­ply (the re­sult of less bor­row­ing in a pro-cycli­cal frac­tional re­serve bank­ing sys­tem). In such cir­cum­stances, a re­ces­sion is al­most in­evitable, and equity mar­kets are likely to re­flect the com­ing slow­down.

To­day, the spread be­tween the re­turn on cap­i­tal and its cost is shrink­ing, which makes it clear that the US econ­omy is in the sec­ond half of the cy­cle. First quar­ter data con­firmed that The Re­turns On Cap­i­tal Are De­te­ri­o­rat­ing (a trend which is likely to con­tinue for the rea­sons out­lined last De­cem­ber in The State Of The US Econ­omy). Mean­while, although credit spreads have nar­rowed from the ex­tremes seen in Fe­bru­ary, the cost of cap­i­tal for busi­nesses is now con­sid­er­ably higher than it was 12 months ago. As a re­sult, the spread be­tween the re­turn on cap­i­tal and its cost con­tin­ues to shrink—which is char­ac­ter­is­tic of the lat­ter half of the cy­cle. How­ever this ROIC-COC spread re­mains pos­i­tive, which in­di­cates it is too early to ex­pect re­ces­sion, or to sell-out of eq­ui­ties al­to­gether.

This way of view­ing of the cy­cle sug­gests a three stage in­vest­ment strat­egy:

1) Re­cov­ery phase: go all-in, risk-on! This stage is de­fined by a pos­i­tive ROIC-COC dif­fer­en­tial, with the spread ei­ther stable or widen­ing.

2) Late cy­cle phase: main­tain a bal­anced port­fo­lio. This stage oc­curs when the ROIC-COC spread starts to nar­row, but re­mains sig­nif­i­cantly pos­i­tive—like to­day. In this en­vi­ron­ment, eq­ui­ties tend to out­per­form cash, although cash hold­ings can be used to re­duce port­fo­lio volatil­ity as the cy­cle ma­tures.

Bet­ter yet, in­vestors can hedge with gold or long bonds. Since the early 1980s, the per­sis­tent de­cline of in­fla­tion and bond yields has made long bonds the bet­ter choice (as Charles has shown). This long term trend may hold for a while longer, but at cur­rent lev­els the risk-re­ward propo­si­tion for bet­ting on a con­tin­u­a­tion is poor. If in­fla­tion re­bounds and bonds sell off, gold will be a bet­ter hedge than bonds, as it was in the 1970s.

3) Re­ces­sion phase: get out! When the cost


cap­i­tal ex­ceeds re­turns, get out. Go all into cash, safe bonds or gold. But not yet.

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