Just as the tides follow a predetermined cycle, strategic asset allocations adhere more closely to a specific asset allocation objective over longer periods of time, aiming to maintain balance and alignment to investment views that may take three-to-five years to play out. Much like a cargo ship ignoring smaller waves while the captain looks out toward the horizon, a strategic investment time horizon is designed to disregard short term market gyrations and focus on longer term drivers of returns.
These asset allocation decisions, which may take several years to play out, take more heed of valuations and fundamentals, among other factors, to guide us on the long-term direction of markets. Valuations have historically correlated well to long-term stock market performance, much more than market performance from year to year.
Despite looking out over a strategic horizon, a strategic outlook can change from year to year in response to significant shifts in the drivers of long-term returns, a large structural change in the macroeconomic environment, or a change in asset class characteristics.
Investing over a tactical time horizon, on the other hand, resembles the dynamic nature of changing tides, responding to short-term market conditions like the unpredictable surges and waves in the sea. Like a sailor in a small boat who is heading north may adjust sails to veer east, west, or even south to pick up strong winds or avoid turbulent waters, a tactical asset allocation process tries to be more nimble, seeking to capitalize on timely market trends and fluctuations by making more frequent adjustments based on technical analysis and current market fundamentals. A tactical asset allocation decision places less emphasis on valuations, which have been shown to have less predictive power over shorter time periods of a year or less.
Because of the distinct nature of the drivers of investment returns over these distinct investment time horizons, there can be times when the strategic and tactical asset allocations do not align with one another, even though they both have the same overall goal of exceeding their respective benchmarks. Much the same way as the captain of the cargo ship and the sailboat are heading for the same destination, they just take a different, and sometimes even opposite, route to get there. For example, valuations on international equities can be attractive, yet a tactical view, which puts less weight on valuations, could lead to a domestic equity overweight.
With the Federal Reserve’s (Fed) aggressive rate-hiking campaign of 2022-2023 behind us, we have entered 2024 with an equity risk premium (ERP) slightly below zero. The ERP compares the earnings derived from equities to the income (or yield) offered by high-quality fixed income. A near-zero ERP is a far cry from the 5% level back in March of 2020 at the depths of the pandemic lockdown when the Fed took its target rate to zero and the 10-year yield plummeted to the lowest levels ever recorded near 0.5%. Equities offered tremendous strategic value back then, but less so now.
We expect below average economic growth over the next few years due to structural factors (e.g., slow population growth, deficit spending, and increased cost of debt) but do anticipate inflation falling back to the Fed’s target rate. Coupled with full valuations currently, the equity markets do not currently offer much perceived value relative to fixed income over a long-term strategic time horizon.
Bottom line, akin to the winds that drive a ship forward in good times, we are trimming equities back to neutral due to rich valuations relative to fixed income. This adjustment reflects a cautious stance in the face of evolving market conditions, emphasizing the importance of balancing and managing risk and reward over a three-to-five-year horizon. Fixed income, like a sturdy anchor that can prevent drifting off away in turbulent waters,sees increased core holdings recommended for diversification and income stability amidst competitive yields.
Alternative investments, acting as versatile sails that can be of use in changing winds,offer valuable diversification opportunities to navigate uncertainty. We suggest a shift towards less market-sensitive strategies to enhance portfolio resilience in the face of potential volatility and economic surprises in the months and years ahead.
While strategic investing provides stability and a long-term growth goal akin to the rhythmic tides, tactical investing offers flexibility and responsiveness to short-term opportunities and risks. Both approaches have their merits, and an investment approach that combines both can be particularly compelling for investors. Market timing can be very dangerous. Consequently, we include tactical shifts within a strategic asset allocation, hoping to obtain the best of both approaches. The idea is to take advantage of small tactical opportunities within a given portfolio to obtain superior returns
The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
• Data provided by Bloomberg, FactSet, and LPL Financial, tracking #557620.
• US Treasuries may be considered “safe haven” investments but do carry some degree of risk including interest rate, credit, and market risk. Bonds are subject to market and interest rate risk if sold prior to maturity.
• The Standard & Poor’s 500 Index (S&P500) is a capitalization-weighted index of
500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
• International investing involves special risks such as currency fluctuation and political instability. These risks may be heightened for investments in emerging markets