Portfolio Policy

Bullish over long run, but cautious for now

In this post I will discuss my current asset allocation strategy for my personal portfolio.  I am bullish long term, but cautious over the short term.  I recommend a portfolio with a healthy weight towards equity, but I also think it is important to hedge against near term risks.  In my portfolio my equity position is weighted towards high yielding stocks, I have a large cash position, exposure to commodities and high yielding fixed income.

To be more specific my recommendation is to have ~60% in equities, 20% in fixed income, 5% to 10% in commodities, 2.5% in a currency ETF and 10 - 15% in cash.  Below I will explain my reasons for this asset allocation strategy, and here is a link to a recent Barrons survey of the top wealth managers and financial advisors with their asset allocation recommendations.
  
Over the long run I think the global economy and the global equity markets will continue to grow.  I will explain why I think the U.S. economy will grow shortly.  On the other hand there are several near term risks which could potentially cause a large drop in global equity markets.  These include but are not limited to the European debt crisis, oil prices, Middle East tensions and slowing Chinese growth among other things.  Each of the above could cause a decrease in global growth forecasts and the European crisis could cause contagion similar to the 2008 crisis if Greece or another country goes into a disorderly default.  These risks are why I suggest a 10-15% cash position (liquidity in case there is a large drop) and why I may increase my commodity exposure from 5% to 7.5%.

Now I will discuss why I am still bullish on U.S. equities for the long run and why 60% of my equity position is in U.S. stocks.  In "The Little Book of Economics" (a great quick overview of the U.S. economy) Gregg Ip explains that over the long term economic growth is driven by two things: population and productivity.  Productivity is driven by capital and ideas.  It is for this reason I believe that over the long run the U.S. economy will continue to grow.  Both population and productivity have an environment conducive to growth (Increasing life spans, immigration, education rates etc.).  However, I do think the economy will grow less quickly than it has over the past 20 years due to the aging baby boomer population and the burst of the housing bubble among other things.  Most forecasts currently have been in the ranges of 1% to 3% for the next 5 or so years.  For example, Jeremy Grantham in a February 25 Barrons article stated his forecast for the U.S. economy over the next 7 years is 2 to 2.5%.  I think these are safe forecasts given the recent jobs and housing numbers.  According to investorfriend.com a realistic long term growth rate for the market can be calculated with the following formula: 3% for real GDP growth + 1.5% for inflation + 3.0% for dividend yield = 7.5% long term annual return on stocks.  In the below chart you can see that for rolling 30 year periods from beginning with 1930 and ending with 2010 that DOW returns have roughly tracked GDP growth.

 

* credit: http://www.investorsfriend.com/return_versus_gdp.htm

That being said I think at 13 times earnings the market is fairly valued at its current level, but it is no longer undervalued in my opinion due to the many near term risks and a decrease in long term growth forecasts.  A quick and dirty way to arrive at this conclusion is by calculating a target PE ratio using the below calculation.

Warranted PE = Dividend Payout Ratio/ (Cost of Capital - growth rate)
Where x = .35/(.095 - .07)
Warranted PE = ~14
Current S&P 500 PE = ~13

Of course this calculation is very back of the envelope and is by no means the law, but is merely a quick way to get a feel for the level at which the market is trading.

Below is my recommendation for how to weight the equity portion of a portfolio along with a few reasonably priced mutual funds with good performance records which require a minimum investment of around $1,000 as well as few ETFs.

Weight	Mutual Funds		ETFs
U.S. equities: 60%	LEXCX, ARTLX, AMANX or BAEIX		DIA, VIG
REIT ETF: 5%	none		REM
International equities: 15%	ARTKX, OAKIX, NAWGX		EAF, CWI
Global Emerging Markets: 15%	ODMAX, GTDYX, GEGAX		VWO
Frontier Market Fund: 5%	ODMAX		FRN, VWO

Thanks for reading.