A 2010 equity portfolio: what I think it should look like today

Before we start, remember what we’re trying to do.

We’re not trying to analyze (much less solve) all the world’s problems.  We’re not trying to have a lot of opinions about different stuff.

We are trying to figure out what the most significant factors influencing stock market performance will be this year.  We’re going to divide these factors into ones we have very strong conviction about–or, alternatively, ones we want to build into your portfolio–and the ones we don’t.

Then, we’re going to construct a portfolio that will outperform if the things we have the strongest conviction in turn out to be correct.  At the same time, to the extent that we can, we’re going to neutralize (index-weight) the areas where we’re relatively clueless, so that we don’t get hurt by fooling around with things we don’t know much about.

Here’s what I think:

1.  Q:  Will 2010 be an up year or a down year?  A:  Probably up.  10% higher than now is my rough target.  Basically, the 10% number is less important than the idea that I don’t think there’s any reason at this point to be in a defensive shell.  World economies are growing again.  Chances of sliding back into recession are diminishing.  Economic forecasters are cautious, projecting growth of about half the norm for coming out of recession.  Security analysts are as well.  So expectations are probably not too high and are, if anything, too low.

At some point this year, the Fed will start to raise interest rates again.  If it gets the timing wrong, it will be by being too late rather than too early.  The last times this happened were in 1994 and 2004.  In both cases, the stock market dipped when the process started.  But the S&P ended 1994 down about 1% and in 2004 was up 9% or so.  Two points:  rate rises are not a “today” issue for me–more like a three months from now issue; there’s some chance rate increases won’t be as bad for stocks as one might think.

I think the consensus is split between thinking the market will be up mildly and down mildly.

2.  Q:  Will economic growth be better inside the US or outside?  A:  Outside.  This is not a question American portfolio managers usually ask themselves.  But with just about half the revenues of the S&P 500 constituents coming from abroad, it’s a key one.

The centers of the financial meltdown, the US and the UK will probably be the weakest areas, with the rest of the EU suffering some collateral damage.  Growth in the rest of the world will be much stronger.

This implies we should tilt the portfolio toward foreign revenues.  As a practical matter, it may be easier to achieve this result by avoiding areas like utilities, retail or regional banking that are predominantly/exclusively US.

Remember, too, that “foreign revenues” also means tourism to Disneyworld or business travel to NYC or SF.

American investors usually don’t ask this question, so I don’t think there’s an explicit consensus.

3.  Q:  What about operating leverage?  A:  Look for it.  Operating leverage is the idea that a company with high fixed costs can experience large changes in profits from small changes in revenue.  It’s also something that less experienced analysts usually miss.  My guess is that operating leverage will work in companies’ favor this year.  Hotels, where expectations are very low, are the place I’d look.

The part of the consensus favoring an up market has to be thinking this.  The rest of the market wants to avoid these sorts of stocks.

4.  Q:  How will consumption play out?   A:  I have no hard evidence, but I suspect that there will be a sharp difference between buying patterns for Baby Boomers and for Gens X and Y.

I think the financial crisis has come as a shock to a generation of older Americans on the verge of retirement.  A large number have defined contribution pension plans, whose value depends on the success of the investment choices the owner makes, rather than defined benefit plans, which are basically a check in the mail every month.  Intellectually, I’m sure most Baby Boomers could have told you that they–rather than the companies they work for–are shouldering the risk that the money set aside for retirement might not be enough.  But the financial collapse has brought that fact home in a whole new way.

My guess is that spending by fifty- and sixty-somethings is not going to rebound with the economy.  Frugality will be the Baby Boom watchword.  And as this group gradually does retire, its consumption will downshift further.

On the other hand, the recession has caused Baby Boomers to stay in their jobs a bit longer–meaning they are not freeing up the positions that new college graduates usually fill.  As the recovery unfolds, this situation will change.

In short, I think that younger workers will be getting jobs/raises for the first time in a couple of years at the same time as Baby Boomer consumption begins to tail off.

So what?  In thinking about consumption, look for what younger people will likely buy–smartphones, netbooks, video games, e-readers, movie downloads, vacations, Volkswagens.  Forget about luxury goods, second homes, cruises, the most upscale clothing designers.

How to play this?  The best I can come up with is fabless semiconductor firms that specialize in chips for consumer products.

No one is talking about this.

5.  Q:  What about emerging markets?   A:  I think it’s important to distinguish between emerging economies, which I believe will continue to boom, and emerging markets, many of which are driven by inflows of money from the developed world.   In a developing country where there are no formal pension plans and where the average worker earns, say, $2,000-$5,000/year, there are virtually no buyers to absorb the selling should foreigners choose to leave.  (Just to make sure you’ve calibrated your thinking to appreciate how a developing economy runs, think soft drinks as a luxury good and aspirin as one of the few affordable medicines.)

The two lowest risk ways to get exposure to emerging markets are through emerging markets funds–either actively managed or index funds–or through owning stocks in developed markets that have substantial emerging markets exposure.

The higher risk route is to own either single country funds or individual stocks in an emerging market.  (As someone who has 25 years experience in smaller markets, in the latter case you’d better be sure you know what you’re doing.)

This is the consensus view–meaning it will either be very right (but not a differentiating factor) or horribly wrong.

6.  Q: Are investor “tastes” changing in the US?  A: I don’t know.  “Taste” is a catch-all phrase used in the academic world to describe investors’ risk/return preferences.  I can’t help thinking, though, that Baby Boomers are going to eventually discover dividend-paying stocks as an attractive alternative to bonds or bond funds.  An aging investor base change the character of the US stock market over the next decade–but not over the next year.

No one is talking about this.

7.  Q:  Where is the dollar headed?  A:  I think the weak state of government finances and the lack of responsibility in Congress mean it’s heading lower.

Opinion is split, I think.  If pushed, most would probably say:  short-term stable, long-term lower.

How to craft a portfolio from these thoughts

We’ll take two cases–a portfolio using only sectors, and one using individual stocks as well.  Let’s also stick to the idea that 80%-85% of a person’s equity allocation will be an index fund.  We’ll be free to do what we want with the rest (obviously, you have to first do an assessment, either by yourself or with professional help, of your own objectives and risk tolerances, in which you conclude that you’re okay with this).  Note that you may have a completely different set of thoughts about the economy or the stock market–in which case the process is the same, but the resulting portfolio may be considerably different.  Also, if it’s right that market gains will be in the 10%-15% range, it will probably be difficult to get significant outperformance without holding individual stocks.

CASE 1–sector weightings only

If the economy continues to recover and the market is likely to go up, then we should be holding economically-sensitive sectors–IT, Materials, Industrials, Consumer Discretionary.

IT, Materials and Industrials (to some degree) should do well if foreign growth is better than domestic.  Utilities and Telecom should lag.

You can find capital-intensive, high fixed cost businesses in almost any sector, but I think IT, Materials and Industrials have more than others.  Telecom and Utilities also fit this description but heavy government regulation puts them in a somewhat different category.

If my young/old consumption split is right, that should be good for IT.

Emerging markets exposure is really a question of risk tolerance.  I’ll leave that up to you.  Myself, I own some Chinese stocks listed in Hong Kong, a couple of actively managed Asia funds and the Vanguard emerging market index fund.

This brings us to what to do.

The sectors I’d overweight, based on top-down factors, are IT and Materials.  I’m a bit concerned that these sectors have so strongly outperformed the defensive part of the market over the past nine months.  At some point, the idea that “a rising tide lifts all boats” must include Utilities and Telecom.  On consensus estimates, Materials also looks highly valued.  I’m less concerned about that, since these companies’ earnings are notoriously difficult to predict.

Anyway, of the 15% of the portfolio reserved for active management, I’d put 5% each into IT and Materials and leave the rest in the index.  I would intend to invest the other 5% in economically-sensitive sectors, but I’d prefer to see defensive sectors do some catch up first.

Case 2–individual stocks also allowed.

I would have the same IT and Materials overweight as in Case 1.

I’d use individual stocks to try to get more focused exposure to the consumer.  The most conservative way of doing this would be to buy WMT (which also has a 2%+–and rising–dividend).

As a former holder of Marvel Entertainment, I’m now a DIS holder.  To my surprise, I kind of like the company (by far its biggest business is ESPN).  A revival of its movie business and a return of patrons to its US theme parks–either domestic residents or foreign tourists–could do wonders for its bottom line.  But DIS is a step further out on the risk spectrum.

ATVI (which I own and which has been a poor performer) would be another step up in risk, but it certainly captures the under-forty audience.

For this portfolio, I’d buy a 2.5% position in ATVI and a 2.5% in DIS.  I’d probably also want to add a fabless semiconductor design firm, but I haven’t done enough work to decide which one.

2 responses

  1. Very interesting and valuable overview. I also think that my
    Baby Boomer compatriots are going to discover dividend-paying stocks,at least I hope so since I own a lot of them. For those in bonds, I suspect that rising interest rates this year (and falling bond prices)will accelerate that push toward dividend stocks as well.

    I agree also that growth likely to be outside rather than inside the U.S. but What does that imply for the 85% of your portfolio which is given over to index funds? A split in allocation between an S&P 500 Indexer and a Total World ex-U.S. Index fund or ETF? Or simply to rely on the fact that a big chunk of the S&P are large firms with lots of customers “outside” for exposure to non-u.s. stocks?

    I would like to see you expand on the emerging “markets” vs. “economies” definitions, preferably by giving examples of countries which, in your view, “fit” in one category or the other. The average worker in Shanghai, for instance, earns roughly $3,200 USD/annum, right in the middle of your income range example; is China therefore an emerging “economy” or an emerging “market”? Intuitively, I would say the former, or perhaps really both, but these terms often confuse me as I read the financial journals. Also, what’s the difference between an “emerging” and a “developing” economy/country? Inquiring and confused minds want to know!

    As always, a thoughtful and bracing tour d’horizon of 2010. I look forward to lots more.

    • Thanks for your comment.

      On “developing” vs. “emerging,” I think they’re synonyms now. Emerging was originally used to refer to the stars of the developing world, like China, that seemed to be making the leap from developing to developed.

      You make a really important point in distinguishing between economies and (financial) markets. A lot of what’s written in financial publications assumes, incorrectly, that there’s no difference between the two–that wealthy countries have well-oiled stock markets and poorer countries don’t. A good counterexample is Germany. Very few companies are listed and, until ten years or so ago, trading was dominated by London-based investors who rushed into and then back out of German stocks every few months.
      I’ll take up your suggestion and write about this in the next week or two. The point I was trying to make is that one “extra” risk for investors in the stock markets of developing countries is that there are likely few dedicated local buyers to lend stability. The economy may be fine, but If foreigners get scared for some reason and decide en masse to leave, the bottom will drop out of the market anyway.

      On 85%/15%, my thought is that someone shouldn’t deviate very much from this unless he/she is:
      –willing to put in enough time to understand and monitor the non-index investments,
      –is in a financial situation sound enough to take on extra risk, and
      –understands the extra risk and is still able to get a good night’s sleep.
      I also started this blog with the idea of building a set of investing tools and offering advice to Baby Boomers like me, who are at or nearing retirement age, and for whom managing their own accumulated savings is a key task. It seems to me that for us the scales should be tipped a bit in favor of preserving capital rather than making maximum gains.
      Having said that, I find myself thinking I have to provide a second track for more aggressive, or more interested, investors. First of all, I’m in this camp. Also, I’m thinking that even staying in the 15% “active” guideline, indexing may not be a sharp enough tool to achieve meaningful outperformance.

      I’d appreciate any feedback you or other readers may have.

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