Thinking Process: Portfolio Asset Allocations

According to Merrill Lynch Fund Managers Survey, one of my favourite sentiment indicators, the current portfolio asset allocations are skewed towards Equities at 27% overweight (down from 67% in Feb 2011) and Cash at 18% overweight (up from -9% underweight in Feb 2011). Commodities are now third on the preference list out of four main asset classes sitting at only 6% overweight (down from 28% overweight in Feb 2011) while Bonds, which have been the most hated asset class out of the four, have improved somewhat to -35% underweight (from -66% underweight in Feb 2011).

Note: A total of 282 fund managers with $828 billion of assets under management participated in the survey from June 3 to June 9. The next survey update will be in the middle of July.

Cyclical sectors like Financials and Technology have been in a sell off mode since February 2011, just as the euphoria was at full swing. If the look at the allocations in another way, by taking a spread between "safe assets" like cash or bonds, and comparing them to equities, what we saw in February 2011, was the highest spread within a decade. In other words, managers were more overweight equities compared to cash or bonds, than in any other month since the survey itself began. Therefore it should also not come as a surprise that both cash as well as Corporate & Treasury Bonds have out-performed since than.

Where to from here? If you are feeling somewhat similar to the picture above, you are probably not alone. No one is Nostradamus to get everything right. What I try to do with this blog is put forward my own thinking process as a trading dairy, which also helps me think more clearly. The way I see things is sort of like this - majority of fund managers do not count commodities as an asset class, so they either allocate their portfolio funds between equities, bonds or cash. Lets run through them to see what would be the smartest investment option right now, after a 8% correction on S&P 500 and a 10% rally in Treasuries...

Cash - in the US you have 0.25% on the Fed Target Rate, which means you barley get anything extra on bank term deposits or short term Treasury Bills or Notes. The 1 Month Treasury Bill was yielding negative 0.005% on Friday, while the 2 Year Note yield is approaching record lows. You are barley going to make any money here, so the best you can do is use this vehicle as a safe haven when other asset classes are correcting. Obviously, you allocate money out of Cash or Bills as soon as you think the correction is over, because if you stay here for too long, your money will be eaten up by inflation.

Bonds - the current inflation rate in the US is slowing edging towards 4%. Shadow Stats reports the old method of calculating inflation from the Jimi Carter era, which shows that inflation is actually running above 11%. But even if you do not believe those numbers and would rather side with Chairman Bernanke's "freshly altered" numbers, you should notice that the majority of the Treasury yield curve in now returning negative real interest rates. The yield on the 10 Year Note is currently at 2.84%, meaning that as an investor right here you will be receiving a whole 75 basis points of negative returns. As a matter of fact, the 20 Year Bond yield is barley above water compared to inflation. Therefore, if you are a buyer of Treasuries at the current levels, you have to be ultra bearish on the economy, expecting a huge deflation in prices all across the board. That means agreeing with what The Bernank recently stated, believing that the current inflation is only "transitory" (Note: never got anything right... ever... in his career).

Equities - the current state of economy is not impressive at all. I do admit that. Any one of these soft patches could lead to an actual double dip recession. Greece could default tomorrow if the vote austerity does not pass. There is obviously plenty of reasons to be bearish. And a bearish stance has usually meant that an asset class like equities is dropped in favour of either cash or bonds. But when I look at the options fund managers have between either equities, cash or bonds with inflation on the rise, and than I also look at what the current retail investors views on equities are, with the likes of huge mutual fund outflows, insane level of put buying, bearish readings on sentiment surveys - I come to the conclusion, that this is the best financial asset compared to the other options.

Summary - my view is that the current slowdown is linked more towards the Japanese earthquake that anything else. Therefore, I think the slowdown is temporary. However, a lot of comments on this blog sound like the following:

What about the housing market? And what about the huge unemployment level? And what about tight lending and non-existant credit growth? And what about de-leveraging which will create deflation?

If you believe that these events have not already been priced in with a 60% crash in 2008 as well as sharp spike in Treasury prices, you must have been living under a rock. That was one of the worst stock market crashes in the last 100 years. A crash like that does not occur every few years, but more so every few decades, but the problem is that fear remains fresh in investors minds, to the point where any after shocks tend to be perceived as a potential repeat of that event. But say that I am wrong and the current economic situation is about to get even worse. Well if one must be bearish, than the following might not make sense to you, due to conventional wisdom.

Precisely because one must be bearish, one should therefore sell bonds or cash. Authorities are going to keep printing money at any sign of a slowdown, which will totally murder returns in cash, as well as bonds. Basically, the worse the economy gets, the worse safe haven assets like cash or bonds will perform.

Now... if the economy recovers here, due to an overly bearish stance by US economists as we can see from the Citigroup Economic Surprise Index above, than Treasuries will sell off. On the other hand, if the economy does not recover here, President Obama, General Bernanke and Sergeant Geithner will print more money than QE 1 and 2 put together. Therefore, if you must be bearish on something, be bearish on Treasuries, unlike the majority of retail investors out there. If the economy recovers, bonds will perform badly; and if the economy doesn't recover, further stimulus will lead to even higher inflation, and bonds will once again perform badly. Either way you look at it, Treasury Bonds are not going to be a good investment from here on. If you disagree with this view, the other option you have is to buy puts on the S&P 500 just like every other retail investor...