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Asset Allocation for December 2012

December 22, 2012 Leave a comment Go to comments

It’s been a while since I’ve written about my asset allocation. I guess that’s why the markets are melting down and politicians can’t agree on anything…

I’ve made a couple of small adjustments since my last update. First, here are the new allocation targets:

  • Bonds 3-4% (was 14% last year, at 3.9% today)
  • CDN index 30-33% (was 27.3% last year, at 29.3% today)
  • US index 28-30% (was 29.5% last year, at 30.3% today)
  • EAFE index 33-36% (was 28.8% last year, at 36.4% today)

And here are the index numbers:

  • DEX Universe Bond Index: yield 2.30%. 12-month return: 3.1%
  • TSX: dividend yield 3.04%, earnings yield 5.4%, P/E 18.44. 12-month return: 7.2%
  • S&P 500: dividend yield 1.99%, earnings yield 5.9%, P/E 16.90. 12-month return: 12.7%
  • EAFE: dividend yield 3.13%, earnings yield 5.8%, P/E 17.35. 12-month return: 15.5%

These number surprised me when I put them together. Despite bond yields moving lower, they are actually closer to the stock index earnings yields than they were last year. This can be blamed on stock markets rising, even the EAFE (of which over 60% is based in Europe). And even the fiscal cliff spectacle hasn’t knocked the S&P 500 off its 5-year high. This is disappointing news.

Last year everyone was talking about how it’s a terrible time to be an investor since bond yields have to rise and the stock market was ready to drop again. Unfortunately neither of those things happened so today is an even worse time to be an investor.

Bonds = Bad

Bond yields are still insultingly low. For the last couple of years bonds have defied all rational expectations. Smart investors are usually too early with their calls and I may fall in the same category if I say their yields will go up in the next year. I’m not sure if that will happen but there still seems to be an unnatural desire to own bonds at the moment and I don’t want to follow the herd. Throughout the year I have only added to stock indexes, letting the bond component drift down.

It’s possible that stocks will experience a drop first and holding more bonds would provide extra capital to take advantage of that. However my policy is to form an allocation based on how attractive each investment is over the next 10-20 years, not on short-term predictions. Bonds fall beneath the dividend yield for both the TSX and EAFE and barely top the dividend yield on the S&P 500. And that’s not even counting the earnings yields which are a reasonable-but-not-exciting 3 points higher than bond yields.

They are not an attractive option at the moment. I will not add to bonds until the yields get better. If we see a nice drop in the stock markets I will liquidate the remaining bonds to buy in.

Stocks: Are They Still OK?

The TSX has a reasonably attractive dividend yield but that may not be sustainable since it represents a full 56% of the earnings yield. Either dividends are about to fall or Canadian corporations really have nothing good to do with their capital. Or corporations may be responding to investors who are looking for income anywhere they can find it.  Bumping up the dividend would be a great way to draw in more investors and increase the stock price. In the current environment where individual investors can barely get a positive real return it doesn’t seem rational to want to receive cash rather than leaving it in corporations where it can do more.

The TSX is the worst-performing of the 3 stock indexes over the last year which may make it slightly less risky to go along with its tax advantage. However it’s still an undiversified market so I don’t want to be overexposed to it. As a classic commodity-heavy market it may be held down a bit by the fears of global or continental recessions.

The S&P 500 has had a good year. It’s pushing into higher valuations again which is a bit of a concern since there are some indications that corporate profit levels aren’t sustainable unless the economy really comes back fast. The stock market often moves before the economy so that may be what’s happening. The government manipulation is also a potential negative since it may be increasing the current valuation of the market. Considering that it was in the 1400s 5 years ago, the economy may have come along enough to really push higher this time. The US stock market remains one of the most diversified and active markets in the world so it gets a little extra weighting for that.

The EAFE has unfortunately done the best of the 3 markets. I was hoping bad news would drag it down for a bit longer to give us more buying opportunities but it seems that the bad news is running out. Assuming the EU manages to turn their short-term crisis into a long-term dull pain more investors might come back to the market.

On the other hand the valuation shows that many investors may have already seen through the theatrics (which are almost as good as those in the US) and realized that nothing resembling an open disagreement will ever happen in European politics (we obsequious Canadians ain’t seen nothin’ yet). Or they’ve just seen so much repetitive news that they don’t pay attention to the latest updates and assume everything is really ok. Either way once news starts coming out that reports an “all-clear” in Europe the prices may still have room to move up. I’m still attracted to the EAFE index due to the overwhelming negative opinion in recent times.

Preparing For The Future

Overall I want to be positioned on the right side for rising interest rates, increasing inflation, and surprisingly good economic growth. It seems like a lot of people aren’t expecting much and are still scared of stocks and avoiding them. Of course if we get back to the market participation levels of the 90s and early 2000s stocks could get overvalued again. If things play out well bond yields will have risen nicely by then to let us lock in profits in something that pays actual cash. As always, I’m an optimist!

We’re increasing our monthly investment amount by 25% next month so I’ve adjusted those flows to gradually bring us to the new targets. The differences aren’t big enough to sell anything at the moment.

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