Our active asset allocation Concept emphasises that over time the selection of asset classes is more important than the selection of individual securities.
The investment process functions comprises eight phases running from above with top-down qualitative analysis through timing at the fifth stage to performance measurement as the sharp end of the cone.
The first level is a top down qualitative analysis and looking a few months ahead we see both risk and opportunities.
While the normal pattern is that pessimism takes command before a decrease in interest rates stimulates the stock market, because of a proactive stabilising economic policy in recent years stock markets around the world are not following their normal patterns.
The present situation looks like a period of intermediate consolidation before the final stock market top (phase 3) will be reached in the equity cycle, which includes four phases.
Companies are showing good profit growth but the acceleration phase is over. P/E ratios will probably stabilise and bond yields are most likely to bottom out or rise.
Our qualitative top down analysis Tactical Turning Point Index (TTPI) indicated improvement for equities after the summer. Stocks rose during August on the back of US economic indicators providing firmer evidence that a soft landing is ahead for the US economy. The Federal Reserve also decided to leave the fed funds rate unchanged at the last FOMC meeting.
TTPI is neutral right now but the next change will probably change to bullish
On the second thematic level of our analysis we see growth forces in the (new) economy driven by the technology ‘revolution’ and ‘globalisation’ and combined with higher savings ratios – ‘demographic changes’ to create unique good earnings and stock market conditions.
The third level of bottom-up fundamental analysis shows P/E-ratios at a high in a historical perspective.
However, comparing the ratios to low bond yields and adjusting them for expected healthy and stable earnings growth derived from the new economy’ (i.e. stable and healthy growth with low inflation, which means earnings growth with low volatility, justifies lower risk premium and lower bond yields) we emphasise that the world stock market is undervalued.
On our fourth stage of analysis - asset weightings-quantitative analysis - we maintain a neutral stance towards equities despite negative momentum in our quantitative based intra-market volatility and earnings expectations models.
Attractive valuations based on a soft landing scenario with low bond yields and good earnings growth give a 60-70% probability that equities should outperform both bonds and cash.
At the same time we are overweight in bonds - the reason being that global growth appears to have peaked, creating a positive momentum for bonds but still holding up a yield level that is competitive compared to cash holdings.
In terms of regional allocation we continue to underweight USA and overweight Europe due to valuation matters.
In summary then, with an expected return for global equities of some 10%, global bonds 5,25%, cash 4% and a positive alpha contribution of 2-3% from active management in equities and a market timing ability of some 1-2%, the expected return for the portfolio given current weights (68% equities, 19% bonds and 13 % cash) is above 11 %.
With an investment horizon of five years , these weights can only be motivated if standard deviation for the benchmark stays around 7 % (compare past levels of above 9 %) given the historical correlation’s between the chosen assets (the historical data is based on the performance of the MSCI world index, Dr local currency, JPM Government Bond Index Global based on the time period 1991-2000).
Torbjörn Söderberg is head of active asset management at Stockholm based Trevise Unibank Investment Management in Stockholm.
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