Shaping a Portfolio for 2011 (lV): what I think equity exposure should look like

US stocks

Based on the idea that we have at least one year (and maybe several) of expanding US and overseas economies ahead of us, I think a US portfolio has to continue to be tilted toward economically sensitive sectors and away from defensive or stable growth ones.

True, today’s stock market circumstances are different in some respects from those that prevailed during the second half of 209 and much of 2010.  But the differences are mainly ones of emphasis rather than general direction.

small instead of large

Eighteen months ago, stocks were significantly cheaper.  Skepticism about the potential strength of economic recovery was high. Because of this, there was no percentage for most investors in taking the risk of owning second-or third-tier stocks. Yes, you might have had higher returns from taking on the extra risk…but  why?   You could still have made very good money—and significant outperformance—from buying plain vanilla large capitalization names.

I don’t think that’s true any longer. This year there’s be much more money to be made in smaller names. This isn’t a profound insight (although it will likely prove a profitable one). It’s the normal market progression during an up phase.

growth instead of value

A second element of market maturation, a shift from value stocks to growth names, appears to me to have already begun last September.   This trend will likely continue throughout 2011. Why? Value stocks are typically very sensitive to an upturn in the economic cycle and therefore move earlier.

You might explain this by saying that investors first discount the fact of economic recovery and only later get more specific by beginning to focus on the distinctive aspects of a particular upturn. Or you might say that it’s only after the initial surge of pent-up demand from recession is satisfied that the ability of a growth company to generate steady profit growth from unique or unusual products begins to catch the market’s fancy. In any event, it’s what happens.

sectoral structure

From a sectoral point of view, I think the overweight areas should be—in no particular order:

Materials

Industrials

Consumer Discretionary

IT

Energy

Underweights should be:

Utilities

Healthcare

Telecom

Staples

I personally have one neutral, Financials, because I don’t know enough to have an opinion. So I’ll be content with not gaining or losing relative performance in this sector.

geographical exposure

I’m a US-based investor and am ultimately concerned about returns in US dollars.  I still have a preference for having a considerable amount of non-US exposure, however. But my preference is milder today than it was a year ago and has a somewhat different focus.

For the past two years, both professional and individual investors have asked themselves whether there would be more economic strength inside or outside the US and decided the question was a no-brainer.  They put themselves, correctly, squarely in the “elsewhere” camp, especially in emerging markets.

Several aspects of the inside/outside situation have changed, in my opinion:

–some emerging economies have begun to fear overheating, given the relatively stimulative money policy of the US and the large flows of portfolio capital into their stock and bond markets.  So their governments are acting to slow their economies down.  This shrinks the growth differential between them and the developed world.

–the US is finally beginning to pick up economic momentum, shrinking the relative growth gap further.

–the EU has decided the best road to recovery is to repair government finances as soon as possible, sacrificing near-term economic growth in the process.  This has widened the negative growth gap between the EU and the rest of the world.

The home country/foreign exposure decision depends principally on your personal economic circumstances and risk preferences.  Having said that, I think any changes should be in the direction of:

–more exposure to the US economy, especially retail

–much less exposure to international index funds (which are mostly Europe and Japan, two ugly economic areas at present), as well as European ones

–possible shift away from emerging markets funds toward Pacific ex Japan or China funds

–orientation away from US firms with large European exposure

–considering Europe-based firms that earn most of their money elsewhere.

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