Asset Allocation:
A Recommendation for Resolving the Collision between Theory and Practice
Larry J. Prather (Southeastern Oklahoma State University), et al.
April 26, 2016
We examine the creation of a low-cost optimal risky portfolio that individual investors can easily construct and manage. We consider five index mutual funds and three precious metals that are easy for investors to trade. Collectively, the mutual funds track the returns of the entire U.S. equity market, 98% of foreign stocks, U.S. investment grade bonds, all domestic REITs, and emerging markets. The three precious metals are gold, platinum, and palladium. Because these mutual funds are available in ETF form, we provide optimization results with and without short selling. Optimization results differ greatly from conventional wisdom regarding optimal asset allocation.
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Investors just can’t get enough of low (and falling) yields. There’s a “nearly insatiable global demand for yield,” observes Aaron Kohli, interest-rate strategist at BMO Capital Markets. Where this ends and what it portends is unknown. Meantime, yields continue to tick lower, dipping below zero in some corners. Let’s call it the Star-Trek factor. As the crowd chases bonds with record low payouts, the fixed-income crew is exploring strange new worlds, boldly venturing to go where no investor has gone before.
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Growth stocks have enjoyed an edge over their value counterparts in recent history, but market action of late suggests that the relative return drought for out-of-favor equities may be ending.
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Earlier this month, Deutsche Bank warned that there’s a 60% probability of a US recession, based on the firm’s analysis of the Treasury yield curve. Neil Irwin at the NY Times wonders: “Can We Ignore the Alarm Bells the Bond Market Is Ringing?” But perhaps the better question is whether we can rely on any one signal—or model—for evaluating recession risk? No, we can’t, and fortunately we don’t have to. The one exception for this common-sense rule: combining recession-risk estimates from multiple methodologies and taking the median number as the closest thing to a single, relatively reliable measure of macro distress. On that note, allow me to introduce the Composite Recession Probability Index (CRPI).
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The SPDR Barclays High Yield Bond (JNK) posted a solid 1.5% total return for the shortened four-day trading week through July 8—the best performance among the major asset classes, based on a set of proxy ETFs. The advance marks the second straight week of strong increases for the fund. Part of the renewed allure: relatively juicy payouts at a time when the 10-year Treasury yield has been plumbing new all-time lows amid increased confidence that the US economy will continue to avoid a recession for the near term.
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● Empire of the Fund: The Way We Save Now
By William A. Birdthistle
Summary via publisher (Oxford University Press)
Empire of the Fund is an exposé and examination of the way we save now. With the rise of the 401(k) and demise of the pension, the United States has embarked upon the richest and riskiest experiment in our financial history. Over the next twenty years, nearly eighty million baby boomers will retire at a pace of ten thousand per day. The hypothesis of our experiment is that millions of ordinary, untrained, busy citizens can successfully manage trillions of dollars in a financial system dominated by wealthy, skilled, and powerful financial institutions, many of which have a record of treating individual investors shabbily.
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The pace of employment growth at US companies bounced back sharply in June after slumping to a five-year low in May, the Labor Department reports. The gain, which beat expectations by a wide margin, suggests that the economy is stronger than the May release implied. But note that the year-over-year gain in private payrolls, although fractionally higher, is essentially unchanged from May, holding close to a three-year low. In sum, there’s still no smoking gun for arguing that the US slipped into a new NBER-defined recession, but the weak numbers from other corners of the economy—industrial production, for instance—continue to raise questions about the outlook for this year’s second half.
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The 10-year Treasury yield yesterday took a breather from plumbing new record lows, but it’s not obvious that the 35-year slide in interest rates is over. The benchmark rate ticked up to 1.40% yesterday (July 8) via Treasury.gov’s daily data, a whisker above Monday’s all-time low of 1.37%. All the usual caveats apply for deciding if even lower yields are coming. But if the rest of the world offers a clue (such as the expanding tide of negative rates), it’s premature to bet against a multi-generational trend that’s confounded almost everyone who studies the bond market.
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Private payrolls in the US increased by 172,000 in June, according to this morning’s release of the ADP Employment Report. The gain, although modest by the standards of the last several years, marks the strongest advance since March. But the annual pace of growth dipped to a three-year low, providing more evidence that the labor market’s expansion continues to decelerate.
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After dipping to a record low of 1.37% on Tuesday, the benchmark 10-year Treasury yield ticked higher yesterday (June 6), settling at 1.38%, based on daily data from Treasury.gov. Has the downside bias run its course? The answer awaits in the incoming economic data. Meantime, recent US numbers are sending mixed signals and new questions raised in the post-Brexit world order aren’t helping.
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