David Roda, CFA, Southeast
Mike Serio, CFA, Mt. Northwest
Cam Hinds, CFA, Great Lakes
Marc Doss, CFA, California
Sean McCarthy, CFA, Southwest
Kei Sasaki, CFA, Northeast
William Keller, CFA, Mid-Atlantic

In this Monthly Market Advisor:

  • U.S. and international equity markets as well as bond markets have all experienced rallies so far in 2017. Many investors are asking whether these rallies can continue and whether their portfolios are properly positioned.
  • Each individual investor has unique investment goals, risk tolerance, and personal circumstances that need to be factored into the investment equation.
  • We believe investors should maintain an individualized, strategic asset allocation framework that looks beyond the current economic cycle to determine the mix of assets needed to help achieve his or her long-term investment objectives at the appropriate risk level.
  • In the current environment, we recommend investors consider overlaying their strategic allocation1 with tactical asset allocation2.

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So far, 2017 has been another banner year for investors. U.S. equity markets have delivered impressive gains and hit new highs, while many international stock indices have performed even better. The bond markets have also produced positive returns. These impressive gains have been made despite tepid economic growth, a reversal of Federal Reserve monetary policy, and mounting political uncertainty. As a result, after entering the eighth year of this economic and market expansion, equity valuations are becoming modestly extended and interest rates have begun to tick higher. At this point, many investors are asking whether:

  • These market rallies can continue?
  • Their investment portfolios are properly positioned as the economy rolls into the latter stages of this extended cycle?

To help answer these questions, it is important to understand that each investor has unique investment goals, risk tolerance thresholds, and personal circumstances that need to be factored into the investment equation. Therefore, we believe every investor should maintain an individualized, strategic asset allocation framework that looks beyond the current economic cycle to determine the mix of assets needed to help achieve his or her long-term investment objectives at their appropriate risk level.

Why Strategic Asset Allocation Is Important

A Wells Fargo study suggest that over time, as much as 79 percent of portfolio returns are attributable to strategic asset allocation decisions as shown in chart 1. Therefore, regardless of the current market environment, we recommend relying on a strategic allocation as the foundation for all investment decisions. Any decisions that would create a significant misalignment between the strategic portfolio and the investor's long-term goals should be carefully considered, regardless of the investment climate.

Chart 1. Key Drivers of Portfolio Return Variability

Pie chart of key drivers of portfolio return variability. Contact your Relationship Manager for more information.

Sources: "Determinants of Portfolio Returns," Wells Fargo Wealth Management, 11/11, Wells Fargo Investment Institute

Consider what could have happened to an investor's portfolio with a strategic allocation to the U.S. equity market who liquidated all or a major portion of his or her stock portfolio during the 2008-2009 financial crisis and held the proceeds in cash alternatives as measured by 1-3 month Treasury bills in this example. As a result, his or her portfolio was shifted away from its strategic allocation. Investors who did this and were slow to reenter the stock market after the crisis may not have fully recouped their losses—potentially making it difficult for them to reach their long-term goals. A hypothetical investment in the S&P 500 in October 2007 (at the pre-recession market peak) held through June 2017 would have experienced a 96 percent gain (with reinvestment of dividends) while an investment in 1-3 month Treasury bills provided little or no returns as shown in table 1.

Table 1. Financial Crisis and Recovery Performance

Peak to Trough Return (10/07-02/09)
Entire Period Return (10/07-06/17)
Months to Recover
Bloomberg Barclays 1-3 Month T-Bill 2.77% 3.88% N/A
S&P 500 -50.17% 96.10% 54

Source: Wells Fargo Investment Institute, FactSet. Cumulative total returns as of 6/30/2017. Index returns represent general market results and do not reflect actual portfolio returns, the experience of any investor, or the impact of any fees, expenses, or taxes applicable to an actual investment. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. The Bloomberg Barclays 1-3 Month U.S. Treasury Bill Index includes all publicly issued zero-coupon U.S. Treasury bills that have a remaining maturity of less than three months and more than one month, are rated investment grade, and have $250 million or more of outstanding face value. The S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the U.S. stock market. Stocks offer long-term growth potential but may fluctuate more and provide less current income than other investments. Unlike stocks, government bonds and Treasury bills are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and fixed principal value.

Tactical Asset Allocation Can Enhance Returns

While strategic asset allocation is of primary importance, one should not ignore the remaining 21 percent of the performance attribution pie that is explained by tactical asset allocation and security selection. Of course, there are times (such as 2009 to 2016) when active management strategies did not contribute materially to performance. However, there are other times when tactical allocation and security selection have significantly enhanced portfolio returns. They typically correspond with major inflection points in the economy, a reversal of fiscal or monetary policy, or periods of rising volatility. To some extent, all three of these catalysts are starting to align, and Wells Fargo Investment Institute (WFII) is seeing increasing evidence that tactical allocation overlays and active management strategies may contribute more to risk-adjusted portfolio returns over the next 12 to 18 months.

Some historical context helps to illustrate this assertion. The current economic cycle that began in 2009 has been atypical in three important ways:

  1. This has been the slowest economic recovery since the Great Depression, averaging only about 2 percent GDP growth per year.
  2. The recovery was fueled in large part by unprecedented monetary policy easing. The Federal Reserve enacted a zero-interest-rate policy stance while simultaneously buying trillions of dollars of government bonds.
  3. Until very recently, the slow pace of economic growth did not trigger the broad-based inflationary pressures that typically manifest as the economy expands. This sluggish growth and low inflation prompted the Federal Reserve to maintain its aggressive monetary stimulus for an extended period, which acted as a catalyst to push depressed equity prices to record highs and to drive bond yields to historically low levels.

During this eight-year period of rising valuations, seemingly all boats were lifted. U.S. equities smartly outperformed most international indices, and the correlations between the price movements of individual stocks rose sharply, meaning that stock prices tended to rise somewhat in tandem—despite differences in company fundamentals. As a result, diversification and active management strategies struggled to keep pace with broad market benchmarks, and investors flocked to domestic, cost-efficient passive index funds at the expense of allocations to active managers and international investments.

Many income-oriented investors were enticed to increase their allocations to long-term corporate and high-yield bonds to sustain sufficient income levels to meet their needs. Still others sat on their cash alternatives, waiting for what they perceived as the opportune moment to invest.

In 2017, however, market leadership has changed. More active managers are beating their benchmarks, international stocks are generally outperforming U.S. stocks, alternative investment strategy returns have improved, and correlations within equities and among asset classes have fallen. However, many investors remain heavily concentrated in U.S. equities, others carry considerably more interest-rate and credit risk than they may be aware of, and some may still have too much invested in cash alternatives.

Tactical Asset Allocation

To align portfolios with the changing market dynamics associated with the natural progression of the economy as it rolls into a mature growth phase, we recommend investors consider several tactical asset allocation strategies as appropriate given their specific investment goals and objectives. These strategies are not suitable for everyone; therefore, we believe investors should seek professional advice before acting to determine whether any of these strategies are appropriate given their individual investment goals, time horizon, and risk appetite.

  • Review your international equity diversification. The U.S. economy has recovered faster than other developed economies. As a consequence, U.S. equities have outperformed over time and are now trading at higher valuations than most other developed market and emerging market economies at a time when monetary support is waning in the U.S. but remains in high gear overseas. This policy desynchronization and valuation advantage has favored international developed stocks, and equity market performance leadership has shifted away from the U.S. WFII believes this trend will continue and the diversification benefits will increase as correlation between U.S. and international stocks continues to trend lower.
  • Consider your exposure to both passive and actively managed investment products. Rising valuations have been a major contributor to equity returns in recent years. Price/earnings ratios for many stock indices are tracking at or above their long-term averages, suggesting there's little room for more upward movement.

    In the absence of rising valuations as a contributor to performance, WFII believes equity returns will more closely track earnings growth and companies that disappoint on earnings results are likely to markedly underperform companies that meet or exceed expectations. This suggests to WFII that returns will be lower, volatility will be higher, and security selection will play a larger role in performance and risk management. Likewise, corporate bond yield spreads are very narrow today, with corporate bonds across the risk spectrum paying lower yields by historical standards. Where appropriate, WFII recommends investors consider reducing exposure to long-term bonds that carry high interest-rate risk and underweighting high-yield bonds that currently do not compensate investors fully for the credit risk they are assuming. High-quality, intermediate-term bonds currently offer much of the yield of long-term bonds and carry significantly less interest-rate risk. Furthermore, high-quality bonds typically rise in value during periods of market or economic stress. This negative correlation during market corrections has helped reduce portfolio downside risk. Cash alternatives, on the other hand, typically do not go up or down in value during volatile periods and, therefore, have offered some downside protection. But at today's money market rates, cash and other short-term instruments have not helped provide protection against inflation.
  • For qualified investors, hedge funds and other alternative investments may be a viable strategy. Historically, adding alternative investments to a diversified portfolio has helped reduce portfolio volatility and lower correlations to equity markets and interest rates. Equity long/short strategies, which own stocks that appear to be undervalued and sell short stocks that appear overpriced, may benefit from rising equity volatility. These funds tend to own more long than short positions, so they generally move higher with rising equity markets and lower as markets decline. However, they have historically captured more of the upside than downside performance and, therefore, have the potential to enhance risk-adjusted portfolio returns while providing diversification in volatile market environments. Likewise, relative value strategies that are long and short credit (corporate or government bonds) have historically produced attractive returns with very low correlations to movements in general market interest rates. Given the historically low spreads on corporate debt and sovereign bond yields of countries with clearly different creditworthiness, relative value hedge funds appear well positioned to benefit from rising bond yields and interest-rate volatility.

1 Strategic asset allocation: Investor’s return objectives, risk tolerances, and investment constraints are integrated with long-term assumptions to establish exposure to asset classes
2 Tactical asset allocation: Short-term adjustments to asset class weights that are made based on shorter-term expected performance