Whether it’s investing in equities or investing across asset classes, the key objective for investors is wealth creation. However, the most basic objective is to generate returns that beat the rate of inflation. This helps in preserving the purchasing power of an individual.
As we live in uncertain times, tactical asset allocation is of paramount importance. With that in mind, here’s a possible portfolio allocation strategy for the coming years.
But before we dive in, let’s look at a few relevant observations.
In the fiscal year 2000, the S&P 500 index was trading at 1,440. By March 2009, the index touched lows of 666. Between March 2009 and now, the index has surged by 419% and currently trades at 3,458.
Between June 2013 and June 2019, gold was trading in a tight range of $1,200 to $1,300 an ounce. Gold has surged in the last 1.5 years and recently traded above $2,000 an ounce.
Adjust for split, Tesla (NASDAQ:TSLA) stock was trading at $48 at the end of FY2015. The stock was trading around sale levels in September 2019. In the last one year, the stock has skyrocketed by 798%.
There are similar observations for different asset classes and stocks. When observed over a time period.
A key conclusion is that timing exposure to a stock or asset class is critical to delivering healthy returns. Considering the current investment environment, let’s examine an ideal portfolio allocation strategy that can create value in the next few years.
Gold In the Long-Term Portfolio
I strongly believe that investors need to hold 15% to 20% of their investment funds in physical gold or gold mining stocks.
The reason? The Federal Reserve is expected to keep interest rates near-zero levels through FY2023. As easy money continues to flow, accelerating inflation is very likely. Billionaire hedge fund manager Stanley Druckenmiller believes that inflation can hit 10% in the coming years. In a policy shift, the Fed is also willing to tolerate higher inflation.
It’s also worth adding that holding cash is not a good option if inflation accelerates. Cash will rapidly lose purchasing power.
Overall, in a scenario where inflation can trend higher, it makes sense to increase portfolio allocation to hard assets.
Portfolio Allocation to Defensive Stocks
As an overview, high beat stocks are risky with relatively sharp movements compared to low beta stocks. Given the current market valuation, investors can go overweight on low beta stocks and underweight on high beta stocks.
The S&P 500 index is currently trading at a price-to-earnings-ratio of 35.1x. Valuations look stretched in the near-term and a correction is likely before another round of rally.
In a market correction, low beta stocks are relatively resilient. As an example, when the novel coronavirus pandemic triggered a market collapse earlier this year, Costco Wholesale (NASDAQ:COST) remained firm. COST stock has a beta of 0.69.
Investors need to look for similar low beta stocks that also have a robust dividend pay-out. Lockheed Martin (NYSE:LMT) has a beta of 0.94 and an annual dividend pay-out of $10.4. Even if the stock is sideways in a correcting market, investors benefit from high dividends.
Therefore, within the equity portfolio, I would currently look at 60% allocation to low beta stocks and 40% allocation to high beta stocks. This can vary depending on the age and risk profile of an investor.
Considering Exposure to Investment Grade Bonds
For my investment portfolio, if I am considering 20% allocation to gold and 40% to equities, I would look at a 20% allocation to investment grade bonds.
The reason is to ensure a stable cash flow visibility. A good option for investors is to consider exposure to exchange-traded funds. The Vanguard Intermediate-Term Corporate Bond Index ETF (NASDAQ:VCIT) provides exposure to A- and Baa-rated bonds. With a yield-to-maturity of 1.8%, the ETF is an attractive safe investment.
The key point: When the economic outlook is uncertain or there are political uncertainties investors need to increase their allocation to potentially risk-free bonds. In addition, when equity market valuations look expensive, it makes sense to shift some funds to quality bonds.
Investing In Industrial Commodities
A tactical asset allocation to industrial commodities and the energy sector makes sense now. The novel coronavirus pandemic triggered an economic slowdown. However, the global economy is gradually crawling back to normalcy.
Therefore, it’s a good time to remain invested in industrial commodities and energy. In an economic down-cycle, this segment exposure should be reduced significantly. In an up-cycle, the exposure to this segment should be increased gradually. Currently, the world is in a slow up-cycle.
The portfolio allocation to the commodities sector can be in the form of direct investment in commodity futures or stocks. I would recommend quality stocks.
Freeport-McMoRan (NYSE:FCX) is a good proxy for investing in copper. Stocks like Chevron Corporation (NYSE:CVX) and Marathon Oil (NYSE:MRO) are attractive for investors considering exposure to the energy sector.
Overall, the key point is that investors need to closely watch the phase of the business cycle. They should avoid commodities and energy when the economy is peaking out or when the economy is in a down-cycle.
Tactical asset allocation can help investors generate superior returns that beat inflation and also beat market index returns.
However, portfolio allocation requires some basic sense of economic cycles and market valuations. It’s important to note that the world has a liquidity glut. This liquidity will flow from one asset to another asset class depending on economic triggers.
If investors can identify the movement of “big money,” there is always scope to generate robust returns through tactical asset allocation.
On the date of publication, Faisal Humayun did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.
Faisal Humayun is a senior research analyst with 12 years of industry experience in the field of credit research, equity research and financial modeling. Faisal has authored over 1,500 stock specific articles with focus on the technology, energy and commodities sector. As of this writing, Faisal Humayun did not hold a position in any of the aforementioned securities.