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Catastrophe Investing: Asset Allocation for Stormy Times

To paraphrase Bette Davis, fasten your seatbelts. It’s going to be a bumpy autumn.

The sputtering stock market rally has been largely kept alive by dimming hopes of a tax cut, but a clear-eyed assessment of the toxic climate on Capitol Hill indicates that President Trump’s pro-business agenda is in deep peril, if not DOA. If all that weren’t enough, the continuing economic devastation from Hurricane Harvey in Texas remains incalculable.

And lest we forget about geopolitical risk, North Korea on Monday fired a missile that passed through the airspace over Japan.

The dangers extend from Pyongyang to Washington, DC. As the start of a new session of Congress looms, lawmakers face twin imperatives: raising the nation’s debt ceiling to enable the federal government to pay its obligations, and implementing a federal budget to avoid a shutdown.

Trying to reassure a nervous public, Treasury Secretary Steven Mnuchin last week stated: “We’re going to get the debt ceiling passed.” However, the very next day, President Trump said: “If we have to close down the government, we’re building that wall.”

Welcome to investor risk in the Trump Era. Below, I provide guidance on how to allocate the assets in your retirement portfolio, with an emphasis on the trends that are likely to emerge in the third and fourth quarters.

After it returns in September, Congress will have just 12 legislative days when both chambers are in session to raise the debt ceiling. The next fiscal budget must be in place by October 1. Problem is, the White House is in disarray and lawmakers of both parties are squabbling like children in the playground.

Congressional Republicans are now openly defying the president of their own party. Indeed, the public feud between Trump and Senate Majority Leader Mitch McConnell (R-KY) sets the stage for legislative gridlock.

In the face of these gathering headwinds, the major stock indices closed narrowly mixed on Monday, with the Dow Jones Industrial Average down 0.02% and the S&P 500 up 0.05%. The stage is set for a rough week.

To cope with these uncertain conditions, I’ll show you how to divvy up your portfolio assets for growth, income and safety. But first, let’s quickly look at how the markets did in the second quarter and what this past performance presages for the rest of the year.

Low inflation, global growth…

Gross domestic product (GDP) growth around the world in the second quarter was the most rapid — and regionally synchronized — since 2010. In particular, emerging markets bounced back after several years in the doldrums. Inflation stayed in check and most asset markets experienced unusually low volatility.

This steady backdrop was bolstered by robust corporate earnings. The blended earnings growth rate for S&P 500 companies in the second quarter was 10.2%. Companies with higher global exposure benefited from a weaker U.S. dollar and faster global GDP growth.

Most fixed-income categories in the second quarter posted low single-digit positive returns. As central banks tighten the monetary spigot, the steady rise in interest rates makes yield-bearing and interest paying investments like Treasuries look attractive.

Meanwhile, inflation has been running below the Fed’s 2% target for five years (see chart, with data through July 31, 2017):

Inflation Is Tame… for Now

Source: U.S. Bureau of Labor Statistics

Inflation has been chronically low, but don’t get complacent. At their annual meeting last week in Jackson Hole, Wyoming, the world’s central bankers seemed to agree that inflation won’t be a problem, but these economic mandarins have been wrong before.

You need to manage the risk that inflation could be higher than anticipated over the long haul, as the bill for protracted monetary loosening finally comes due. Inflation-resistant asset classes, such as commodities, gold, commodity-producing equities, and short-duration bonds, have historically held up better when inflation is on the rise.

Slicing the portfolio pie…

The U.S. stock market now sports a cyclically adjusted price-to-earnings ratio of 30, a level exceeded only in 1929 and the late 1990s. With political risks mounting and a correction around the corner, a sensible all-purpose retirement asset allocation right now is 35% stocks, 30% hedges, 25% cash and 10% bonds.

Projected earnings growth bodes well for select stocks, with caveats. For the third quarter, 59 S&P 500 companies have issued negative earnings per share (EPS) guidance and 35 companies have issued positive EPS guidance. The analyst consensus expectation is for third-quarter earnings growth of 5.2%.

You should avoid overpriced momentum stocks and stick to global blue chips that boast strong balance sheets. In particular, multinational consumer giants based in Europe are undervalued and should benefit from rising growth around the world and in the euro zone.

Classic hedges worth considering are gold and commodities funds. The SPDR Gold Trust (NYSE: GLD) and Powershares DB Agriculture (NYSE: DBA) are two quality exchange-traded funds (ETF) that fit the bill. Benchmarks for their sectors, they also boast low expense ratios of 0.40% and 0.85%, respectively. Gold and agricultural prices are expected to rise this year and beyond, making these two ETFs effective hedges against not just a broad market downturn but also an unexpected spike in inflation.

To raise cash levels, consider booking profits on your gainers. In light of the stock market’s big gains and the rising threat of a correction, it’s prudent to take profits off the table.

Bonds are supposed to provide ballast for a portfolio during rough stock market seas, but the price of bonds moves in the opposite direction of yield. When interest rates rise, prices of existing bonds decline. As interest rates steadily move upward, investors are asking: What should they do with the bonds in their portfolio? Should they dump their bonds and bond funds now?

The answer is no. Your portfolio still needs the safety of bonds and not all bonds get crushed when the Fed tightens. Notably, short-term bonds are less vulnerable to interest rates than longer-term bonds.

Consequently, bond ETFs such as Vanguard Short-Term Bond Index Fund Investor Shares (NSDQ: VBISX) or Vanguard Short-Term Bond ETF (NYSE: BSV) should perform better in a rising rate environment than Vanguard Long-Term Bond Index Fund Investor Shares (NSDQ: VBLTX) and Vanguard Long-Term Bond ETF (NYSE: BLV). During past rate-tightening cycles, short-term bond funds have performed better than intermediate-term, long-term or multi-sector funds.

The Labor Day holiday heralds the unofficial end of summer. As autumn approaches, will the broader markets provide one last upward gasp before they pull back? History is against it. September ranks as the worst month for stocks, according to the Stock Trader’s Almanac, generating an average price return for the S&P 500 of -0.5%.

Then there’s the so-called October Effect, which is mostly psychological but nonetheless disconcerting for many investors. Black Monday, Tuesday and Thursday all occurred in October 1929. In addition, the great crash of 1987 happened in October. You’ve been warned.


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