Asset Allocation Update: December 2019

Best Ideas Market Timing uses an asset allocation framework to vary the allocation to stocks around a 70% S&P 500, 30% US Short-Term Treasury benchmark.

The portfolio ended the month with 80%% invested in stocks, 20% in cash and short-term treasuries, and 0% in long-term Treasuries.
Model allocations are currently 80% stocks, 20% cash and short-term US treasuries and 0% long-term US Treasuries (as at 31/12/2019).

This is a higher target weight to stocks (10+% vs benchmark), offset by an allocation to quality/defensive and gold mining stocks.

Current positioning reflects a neutral-to-positive view on US stocks. Here’s a summary of our asset allocation framework as at the 31/12, 30/11 and 31/10.

The overall score ended December unchanged at +2. That said, there have been several important changes underneath the surface.

Our absolute valuation score is now -2. The forward P/E ratio of the S&P 500 is approximately 18x (as at 17/12/2019). The only other time since the GFC that the forward P/E has been this high was January 2018.

The chart below compare the total return (including dividends) S&P 500 (black) with 12-month GAAP earnings growth for S&P 500 companies (blue) and the 12-month trailing P/E ratio of the S&P 500 (red).

Over the last three years the S&P 500 has returned 53.17%. This has largely been driven by earnings growth of 49.17% (the rest is dividends). Meanwhile the trailing 12-month P/E ratio has fallen by -3.46%.

These three-year results hide three very different years. The following three charts show the same indicators, but this time for calendar 2017, 2018 and 2019.

In 2017, the market was driven higher by earnings growth. Valuations were unchanged.

In 2018 earnings continued to grow but the S&P 500 total return was dragged into negative territory by collapsing valuations. In other words, the market got cheap (i.e. higher earnings at a lower valuation multiple).

2019 was the opposite story. Earnings went nowhere all year after two strong years. Valuations played catch up for 2018. Then in October 2019 they took off.

The S&P 500 looks expensive. Does this mean investors should cut back on US equities? Valuation is a poor market timing tool. Especially in the short-to-medium term. The chart below is taken from the Q1 2020 JP Morgan Asset Management Guide to the Markets.

The correlation between the forward P/E and returns over the next 12-months (left-hand side) is negative. But the R2 (i.e. how well the regression line fits the data) is very low. In other words, valuation is a poor predictor of returns over the next 12 months. Valuation is a reasonably accurate forecasting tool over periods longer than five years (right hand side).

All other things being equal, long-term future returns are likely to be lower. It also increases the risk that a correction or a bear market may be more severe.

In other words, risk-adjusted returns for the S&P 500 are relatively less attractive than they were at the start of 2019.

The economy score has risen to = (neutral). Trade war rhetoric between the US and China has moderated, with the signing of a Phase One deal scheduled for 15/12/2019. There are currently no signs of rising unemployment. Industrial production rose slightly in November.

The December US Markit PMI shows a modest expansion in production and new business, partially offset by inflationary cost pressures (higher supplier costs and tariffs). The ISM Non-Manufacturing Survey for November (i.e. services) also shows expansion (53.9%). This is in contrast to the US ISM Manufacturing Survey for November which shows contraction (48.1%).

We downgraded the sentiment score from -1 to -2 in November. There were multiple signs of investor over-optimism. In hindsight we were early. Sentiment has become even more euphoric in December.

The S&P 500 trend remains positive.

All other things being equal, a trend is stronger and more likely to be sustained if the majority of stocks are participating in that trend. This is why breadth indicators are often used in conjunction with trend indicators.

Several breadth indicators are currently at levels that are so good that there’s little room for further improvement. For example, 83.2% of stocks in the S&P 500 are currently above their 200-day moving average. We’re closely monitoring these indicators for divergences that may indicate that the S&P 500’s uptrend is coming to an end.

The Fed cut rates and is effectively providing QE through its market interventions (the Fed’s balance sheet has started expanding again). More and more central banks around the world are getting in on the act.

The biggest change in December has been the strength of the Australian Dollar (AUD). The AUD has been firming since August (i.e. series of higher lows) and it finally broke out of a two-year downtrend in December.

AUD strength was a drag on Best Ideas performance in December. Still it’s not all bad news. A strong AUD is consistent with a risk-on environment (i.e. stocks performing well).

In summary, it’s hard to be bearish when the US Federal Reserve is keeping interest rates low, the US economy is showing no sign of an imminent recession and the market trend is positive.

That said, euphoric sentiment increases the risk of a short-term pull back. High absolute valuations mean that longer-term future returns are likely to be lower.

Our response has been to:

· Tighten (again) the stops across portfolio holdings.

· Allow cash levels to rise slightly as stocks get stopped out.

· Initiate a small position (2.99% as at 31/12) in the Gold Miners ETF.

First-time readers looking for more information on how we use the Asset Allocation Framework score can find it HERE.