An Allocator's Advice
05/05/2006 12:00 am EST
There are few who command a stage and investor attention, like Joe Battipaglia, chief investment strategist at Ryan, Beck & Co., long one of the most popular speakers at Money Shows. An asset allocator, he looks at the state of the economy, stocks, interest rates, and gold.
"Back in November, the market began to price in an end to rate increases in the US. The dollar began to fall as gold turned and moved sharply higher. The value side of the US equity market, which includes interest rate sensitive financial companies extended their multi-year rally. Without support of a rising dollar, large and liquid US equities again lagged their smaller company counterparts and foreign investments.
"Now China is taking notice of some inflation in their own economies and is beginning to take moderate steps to rein in growth. Last week China chose to raise short term rates while Japan held theirs steady. As months progress, however, we would expect both countries to lean toward tightening to temper economic growth. So long as the process proceeds in an orderly fashion, which is no small order for central bankers, we would expect the dollar to move lower, which continues to create opportunity in foreign investing and gold.
"Overall, we see no signs of slowdown and believe that inflation worries are exaggerated. Oil at $70 and 15 rate hikes have done nothing to slow the US economy. Our 'diffusion index' tracks a broad array of economic data including the shape of the yield curve, spending, factory orders, wage and job growth to name a few, and the composite picture remains solidly in expansion mode.
"Anecdotally, factory orders rose by over 6% last month, consumer spending is up 6% year-over-year, the yield curve has grown steeper and inflation expectations are again nearing the high end of the range. It is feared by some that robust growth in economies like China (which reported growth of 10% in the most recent quarter) and higher commodity prices will flow through as higher inflation. But we point out that in the past investment booms in emerging markets often led to an expansion of long-run supply over demand which helps to contain price levels and not the other way around.
"What's to come? Japan and China are now following the United States in raising lending rates- a process that could prove difficult particularly for China as that country seeks to meld government central planning with market based capitalism while simultaneously looking to balance rapid but uneven growth between agrarian and urban centers. This is not easily done and we would not be surprised to see dislocations in the region in the years ahead as the country attempts a delicate balance between globalization and maintaining economic progress and social order.
"Unfortunately, there is no way to lay out a timeline for these developments and the opportunity cost to a portfolio that does not look to take advantage of growth opportunities overseas, particularly as the dollar moves lower, can be very high. At this time, we expect to see continued strong relative returns from foreign markets versus the US as the dollar drifts lower in response to an end to Fed tightening. As tactical allocators, our job is to emphasize assets that appear undervalued. In this case, we continue to see U.S. equities as favorably valued compared to bonds despite the recent rise in yields.
"Currently, the trailing earnings yield on the S&P 500 remains about 50 basis points higher than the ten-year Treasury's 'risk free' yield of just over 5%. A 'normal' range for this spread has been for bond yields to be higher not lower than the Treasury yield by anywhere from 100-300 basis points. So, for example, if we expect bond yields of 5-6% on the ten-year Treasury a normal earnings yield for equities would be 3-5% based on the historic data from 1986-2002.
"Thus, even though there has been some improvement in the level of bond yields recently we are hard pressed (especially without evidence of a deteriorating economy vis-a-vis our 'diffusion index' and in light of continued earnings growth for the S&P 500, which is expected to exceed 10% again this quarter marking the 11th straight quarter of +10% EPS growth) to shift any assets away from equities at this time.
"As for gold, it is difficult to calculate a 'fair value' for an asset that pays no interest, dividend, or generates earnings or cash flow. However, gold has now moved to a level that, when compared to values for broad stock market averages or bond market proxies represents to us a reasonable risk premium when calculating returns on the various asset classes since 1986. The underlying drivers that have prompted the recent rapid rise in the commodity remain in tact, however.
"We continue to see little new supply of the commodity from mines or selling from central banks. At the same time, we are mindful that emerging market economies are natural buyers for the commodity as a substitute investment class for excess central bank capital as well as numerous industrial applications and for personal consumption. Of course, the asset provides additional benefits to those seeking to hedge the dollar's decline or to hedge against geo-political risks including recent tensions with Iran."