Asset Allocation for the Upcoming Year

By: Henry To | Wed, Dec 6, 2006
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Dear Subscribers,

I hope all of our subscribers have had a quiet week. This author was not so "lucky," as most of my efforts over the past week have been fixated on the currency markets (i.e. the relentless decline of the U.S. Dollar Index over the past two weeks). During my time off from thinking about the currency markets and central bank policies, I relaxed by reading the book "China Shakes the World: A Titan's Rise and Troubled Future - and the Challenge for America" by James Kynge, former bureau chief of the Financial Times in Beijing. Kynge is able to masterfully communicate his message of the business implications of China (not just in America but across Europe and the rest of the "developed world" as well) - and he achieved the job in a very entertaining way as well. While this book will not tell you how to do business in China (nor will it help the scholar who is doing his dissertation on China), per se, it will definitely give you a great perspective as to how it will impact the way business is conducted around the globe and where the profit margins will be going forward. There are numerous anecdotal stories - which I have always found to be very important in a book on China since the widely reported data is very unreliable. This is the perfect book and primer for not only the global investor, but the U.S. investor as well. This is probably one reason why it was able to win the 2006 Financial Times Award for Best Business Book of the Year.

Speaking of China, the OECD has just released a report stating that China has now surpassed Japan as number two in the world in terms of R&D spending.

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Let us first do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 809.13 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 689.13 points

As of Sunday afternoon on December 3rd, we are still fully (100%) long in our DJIA Timing System and is still long-term bullish on the U.S. domestic, "brand name" large caps - names such as Wal-Mart (which is now making a serious effort in the Chinese market by acquiring Taiwanese-owned Trust-Mart and naming a more aggressive new head of operations in China), Home Depot, Microsoft, eBay, Intel (which is not only regaining the performance advantage over AMD, but is actually extending it), GE, and American Express. We are also bullish on both Yahoo, Amazon, and most other retailers as this author believes that "the death of the U.S. consumer" has been way overblown. We are also very bullish on good-quality, growth stocks.

It is to be noted here that the ISM Manufacturing Index is a coincident indicator, and not a leading indicator. Folks who are "relying" on the ISM, GDP, and consumer confidence numbers in order to predict the stock market going forward is playing a fool's game. While the stock market is not a perfect leading indicator of the U.S. economy or sometimes - even the state of U.S. corporations - it is to be noted that it is very rare to find economic statistics that can actually be regarded as leading indicators of the stock market. I myself prefer looking at things that have worked in the past - such as breadth, sentiment, and overbought/oversold indicators. Speaking of which, it is to be noted here that the Dow Jones Utility Average - which has historically been a leading indicator of the Dow Industrials and the S&P 500 in most post World War II bull markets - actually closed at another all-time high (at 457.66) last Friday.

But Henry, isn't the economy slowing down right now? Did the stock market or any other indicator predict this current slowdown three or six months ago?

The answer to the first question is "yes" - and the latest auto sales data suggests that the ISM Manufacturing Index should remain below 50 at least for another month. Note I am saying "slowdown" and not "contraction" or "recession." As a matter of fact, the creators and the keepers of the ISM Manufacturing Index has this to say about it: "A PMI in excess of 42 percent, over a period of time, generally indicates an expansion of the overall economy. Therefore, the November PMI indicates that the overall economy is continuing to grow while the manufacturing sector has now entered a period of contraction. "The past relationship between the PMI and the overall economy indicates that the average PMI for January through November (54.1 percent) corresponds to a 4.1 percent increase in real gross domestic product (GDP). In addition, if the PMI for November (49.5 percent) is annualized, it corresponds to a 2.4 percent increase in real GDP annually."" That is, far from signaling the U.S. economy is contracting, the latest ISM reading is still saying that the U.S. economy is still growing at a respectable pace, even as economic growth declines below potential growth.

As for the answer to the second question, subscribers may remember that the U.S. stock market (as well as major stock markets around the world) did experience a significant peak on in early May of this year (during which time we were short via our DJIA Timing System) - a decline which did not end until mid-August for the most part. For the four months ending August 2006, mutual fund outflows from domestic equity funds were the highest four-month running total since the end of October 2002 (when the last cyclical bear market ended). If there had not been ample private equity buyouts or company buybacks, the Dow Industrials would have most likely gone down another 1,000 points before stabilizing. As it turned out, the "professional investors" were buying hands over fist while retail investors were bailing out in anticipation of the four-year Presidential cycle low and the annual October low. As for the world of economic leading indicators, the ECRI Weekly Leading Index had already started deteriorating in early August - suggesting that the U.S. economy was about to dramatically slow down. In other words, both the stock market and the ECRI Weekly Leading Index had successfully foreseen a mediocre GDP growth of 2.2% in the third quarter and the latest sub-50 reading in the ISM PMI.

As subscribers should know, the stock market started pulling itself together in mid August. With the ECRI Weekly Leading Index registering positive readings again since the first week of November, the U.S. economic slowdown (not recession) scenario remains in play. Given that U.S. equities still remain relatively undervalued vs. bonds and commodities, subscribers should continue to hold on to their equity portfolios and their favorite individual stocks for now.

Over the last few commentaries, I have stated that the "year-end surprise" may very well be a rally in the U.S. Dollar Index. Besides the fact that the U.S. Dollar Index is now very oversold, I have also mentioned many other reasons for being bullish on the U.S. Dollar - including an improving budget deficit this year, slowing growth in U.S. dollar-denominated foreign reserves held in the custody of the Fed, and my conjecture that the Euro Zone could very well perform significantly worse than what many economists are currently expecting. Increasing income taxes in Italy and a VAT hike in Germany notwithstanding, it is interesting to note that many countries in Central and Eastern Europe (which have been consuming a growing proportion of Euro Zone exports over the last few years) are now running significant trade deficits - with Turkey running a $32 billion deficit for the 12 months ending September 2006, Hungary running an annualized $3 billion deficit, Bulgaria running an annualized $6 billion deficit (over 14% of GDP), and Romania running an annualized $16.7 billion deficit. While the Hungarian trade deficit has declined approximately 15% year-over-year, it is to be noted that the trade deficits of the other three countries mentioned have grown from anywhere from 25% to nearly 50% year-over-year. Given that exports make up a substantial part of the Euro Zone economy, it is going to be an interesting month and year ahead for the European currency.

Moreover, the latest Commitment of Traders report is showing a near-record short position in the Euro futures contracts - following is a chart showing the net positions of commercials, large speculators, and small speculators vs. open interest for the Euro, courtesy of

Net positions of commercials, large speculators, and small speculators vs. open interest for the Euro

Following is the same chart (again, courtesy of for the British Pound. The only difference being that the commercials now has a record short position in the British Pound Sterling futures contracts:

Net positions of commercials, large speculators, and small speculators vs. open interest for the British Pound

Finally - despite all the rhetoric telling us that the rising Euro is not a concern for either the European economy or European exports, it seems like the European stock markets think otherwise. Following are daily charts (courtesy of showing the German DAX and the French stock markets over the last six months. Note that both the German the French stock markets have been declining quite rapidly ever since the dollar lost its footing against the Euro right before Thanksgiving:

German DAX Composite ($DAX) and French CAC 40 Index ($CAC)

Bottom line: I still believe the U.S. Dollar will rally against both the Euro and the British Pound going to the end of this year and early next year, especially given that it is not in anyone's interest for the Euro or the Pound to rise so quickly. Whether the dollar can sustain its rise depends on the strength of the U.S. economy in the latter part of 2007 and on whether Congress could further cut down the budget deficit. For now, I do not think holders of U.S. dollar-denominated assets have to worry about the continual slide of the value of the dollar.

New Year's Resolution?

As the title of this commentary implies, we are hear to discuss asset allocation for 2007 - and even beyond. It is amazing to me that most of the general population can spend 40 hours a week toiling away in their jobs but don't set aside some time each quarter to determine their asset allocations - whether it is in their taxable savings or in tax-deferred retirement accounts such as a 401(k), 403(b), or an IRA account (sorry, but I am only the U.S. terms here). I realize that this may not be the best way to spend half a Sunday, but saving for retirement and allocating your assets appropriately is imperative for a comfortable retirement - and collectively, is a decision that is just as important as a decision to buying your primary home and finding and marrying the right partner.

For those who spend time on investments (and by definition, those that are reading this commentary is either serious about their investments or even treat investing as a hobby), let us be clear and tell you this: If you are like most Americans or mutual fund managers, your asset allocation (how much of your assets should be placed in domestic equities, international equities, bonds, cash, and so forth) is typically the primary determinant of your future returns. Picking individual stocks isn't for everyone - especially in this day and age when nearly half of the revenues in the S&P 500 components are from overseas markets (thus requiring much more research than ever before) in a market that is dominated by nearly 10,000 hedge funds.

Before you actually determine what your asset allocation should be, you should ask yourself some questions, such as the following:

  1. What is your overall objective? Is it to provide for retirement? Besides retirement, do you also want to fund the cost of college for your grandkids?

  2. What is your investment horizon? Do you need current income to support retirement?

  3. What is your risk tolerance? In other words, what kind of portfolio would allow you to sleep soundly at night? What would you do if your equity portfolio goes down by 20% in 2007? Will you liquidate or rebalance (i.e. sell some bonds and buy more stocks after the decline)?

  4. Do you have any restrictions as to what you can invest? For example, do you prefer to avoid tobacco and alcohol stocks? If so, then you will need to opt for socially-responsible mutual funds instead.

For those subscribers who have not had a chance to work on their asset allocations (it should be noted that a proportionally high amount of funds in 401(k)s are invested in money market funds, especially after the 2000 to 2002 bear market), I encourage you to make it a priority next year. Or better yet, make this as one of your New Year's resolutions. For many subscribers, it may just be as simple as finding three or four different fund vehicles and then allocate your money between them in the appropriate manner. The aim is to find low-cost, simplistic, low-turnover, stable, funds with broad diversification and representation of the investable universe. Based on my experience, the Vanguard fund family fits this bill perfectly.

Founded in 1975 by John Bogle, Vanguard has a great reputation and is one of the few mutual fund families known for its bastion of integrity (the 2003 mutual fund timing scandals notwithstanding, even American Funds - owned by Capital Research - has been investigated by both the SEC and the California Attorney General for making payments to brokers that give it preferential treatment). It was the first to create an S&P 500 index fund catered to retail investors (1976), a bond index fund for retail investors (1986), and an international stock index fund (1990). Today, the Vanguard Fund Family has 114 individual funds (including fund of funds and lifestyle funds) with an average expense ratio of only 0.25%. It also has one of the lowest turnover percentages as a group in the mutual fund industry as well as the most simplistic structure - most of its mutual funds have only two classes of shares, whereas many mutual fund families have five or more classes with many different expense and load structures.

For the simple investor, the three fund structure (consisting of only the Vanguard Total Bond Market Index Fund, the Vanguard Total Stock Market Index Fund, and the Vanguard Total International Stock Index Fund) as advocated by the following WSJ article with periodic rebalancing to adjust for changing time horizon or risk tolerance makes the most sense. If one has zero time to focus on investments, then it may even make more sense invest in a certain LifeStyle or Target-Date fund in the Vanguard Fund Family. For myself - if I do choose to go the mutual fund route - then instead of picking only three, I will pick six to eight different funds from the Vanguard Fund Family and adjust periodically to reflect my changing preferences for large caps vs. small caps, European stocks vs. Pacific stocks, and so forth. For over 95% of retail investors, I do not advocate trying your luck at allocating your money between the different sector funds. Not even most professionals can master such a strategy as to be able to beat the indices.

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Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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