Sizing Up Markets—and Your Investment Strategy
Today’s risks are clear: stock valuations are high, credit spreads are tight and interest rates remain low. A modest tilt toward return-seeking assets still makes sense. But investors should also be willing to look beyond traditional stocks and bonds.
Making investment decisions is rarely easy. But it can be a major challenge to know which way to lean when stocks and bonds both look expensive and interest rates seem as low as they can go—and in some cases are already heading up. Even central bankers, who rarely comment on broad market levels, are taking note: Fed Chair Janet Yellen recently remarked that asset valuations appear somewhat rich.
On top of this, politics and policy have become hard to predict, yet markets have been largely positive and volatility seems to have disappeared. Investors, meanwhile, are left to wonder how long all this good news can last.
THE CASE FOR OPTIMISM
When we widen the lens, the picture seems brighter. The global economy continues to grow, with China and the euro area showing improvement. Labor markets are healthy. Years of central bank easing seem to have ended the threat of deflation. Politicians are speaking about more fiscal spending to spur growth. In other words, the world isn’t such a bad place, and recent market strength makes sense.
The risks, of course, haven’t disappeared. Interest rates could rise more quickly than expected, and the eventual withdrawal of global monetary stimulus could prove more disruptive than many anticipate. Politicians may not keep their fiscal promises. Elevated earnings expectations in the US may disappoint.
How can investors identify opportunities without exposing their portfolios to unwanted risk? The trick is to have a disciplined investment process that’s broad enough to pursue opportunities wherever they arise and dynamic enough to react quickly when conditions change.
Here are three things that we think investors can do (Display):
1) REMOVE THE SHACKLES TO SOURCE PORTFOLIO RETURNS. While a simple passive mix of stocks and bonds may have treated investors well so far this decade, the forward-looking opportunity isn’t nearly as bright. The expected return for a traditional 60/40 stock/bond portfolio over the next decade is a historically low 4.5%—well below most investors’ expectations.
Investors who hope to improve on that outcome will need to think creatively. That may involve incorporating long/short strategies that can exploit mis-pricings within markets and take advantage of the many behavioral biases that create persistent return opportunities.
It’s important that these alternative strategies include a wide range of exposures that diversify an investor’s broad market exposure. The ideal strategy would have low beta—or market exposure—to both equities and bonds.
It can also help to blend passive strategies with high-conviction active ones. The return streams of each tend to be uncorrelated, which can make a portfolio better suited to weather all kinds of market environments.
Finally, tilt the portfolio toward strategies that stand to benefit from higher inflation. Reflation-sensitive strategies (e.g., real assets, deep value) are attractively valued and can add incremental returns.