Strategy Update – Shifting The Balanced Between Equities And Fixed Income

Last week, AAMA initiated a shift in its Balanced (or Strategic Balanced) allocation model. The strategy, which previously maintained a 60% allocation to equities, has been rebalanced to a target 50% equity exposure.

Why Lower The Equity Exposure Today?

Equity valuations have become overvalued over the past few years. The over-valuation rivals those of 1999-2000, 2008-2009, and 2020, with December 2020 the most extreme.  However, this is the first period of over-valuation since the Great Financial Crisis when interest rates have been above the earnings yield of the stock market. 

When evaluating stocks, it is appropriate  to compare the earnings of stocks to interest rates.   Since 2009, interest rates have been repressed. Over the past 18 months rates have risen significantly, changing the valuation of stocks relative to bonds. Today, stocks are discounted at a risk-free rate of 5%, instead of zero.

By these metrics, considering the higher interest rates and elevated stock market valuations, the stock market is nearly as over-valued as any we’ve seen. This fundamental change means the risk premium of equities has fallen, and equities are no longer more attractive, relative to safer assets.

Because of this fundamental shift, it is appropriate to reduce the equity allocation target in our Balanced portfolio from 60% to 50%.

What Should Advisors And Investors Know Today?

It’s important to note that this allocation update is not a forecast for future long-term market performance or valuations. It’s simply a response to the measurable, fundamental factors at play in the market today.

Equally important, is the consideration of investor goals and time horizon. AAMA has lowered the equity target in its Balanced allocation model to 50% (the allocation can range between 40% and 80% of the portfolio). This strategy is dynamically adjusted to pursue moderate long-term appreciation of capital for investors who seek upside capture, but who also require some active downside risk management.  The Balanced portfolio strategy may be more appropriate for more conservative investors, or those with shorter investment time horizons.

For an aggressive investor with a long time horizon, the changing equity risk premium might not be as relevant.

Where Is AAMA's Fixed Income Allocation Focused?

AAMA’s fixed income positioning remains in short-term and high-quality debt instruments — a strategy initiated to reduce the risk to principal in a rising rate environment. The prolonged inflation fight provides confirmation for our fixed income positioning. We’ve seen high volatility in longer-maturity bonds as expectations around a Fed pivot rise and fall (a cycle we’ve seen multiple times over the last two years). To date, we’ve avoided much of this volatility. Our short-term and high-quality positioning will remain consistent until the inflation fight is clearly complete and the interest rate environment changes.

Where Is AAMA's Equity Allocation Focused?

While there is some variance between strategies, based on risk objective, AAMA’s equity positioning remains focused on large cap companies, with a tilt toward defensive sectors and with an emphasis on balance sheet quality. While the market is widely overvalued, there are segments of the market with stronger earnings forecasts and/or lower earnings and price volatility. Healthcare is an example, with a double-digit earnings growth forecast, moderate short- and long-term price volatility, and just half the earnings volatility of the S&P 500.

Want To Learn More?

If you would like to learn more about our fundamentally-rooted investment process, our risk-adjusted portfolios, or our views on the markets and economy, click here to contact us. We’d love to speak with you.

The information and opinions in this report have been prepared by the investment staff of Advanced Asset Management Advisors (AAMA). This report is based upon information available to the public. The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but AAMA makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this report constitute AAMA’s judgment and are subject to change without notice. This report is provided for informational purposes only. It is not to be construed as a recommendation to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction in which such an offer or solicitation would violate applicable laws or regulations.

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