A simple framework for multilevel investment decision making

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by Bob HomanChief Investment Officer, ING

aAggressive investors can try to beat the market in a variety of ways. Excess returns, or alpha, can be achieved through asset allocation and product selection. First, determine your top-down asset allocation. According to your current view, do you want to invest more or less in stocks, bonds, cash, and their alternatives in your portfolio? Second, which regions, sectors, and styles should you place more or less emphasis on in your stock portfolio and in your fixed income portfolio? Select whether to emphasize interest rate (duration) or credit risk. Third, choose the stocks or bonds you want to buy. Her first two steps can be determined using a simple framework. In this article, I will discuss this framework by focusing on its four elements, and then outline my current views. The four factors are economic growth, interest rates, valuations, and sentiment.

economic growth

Let’s start with economic growth. Economic growth is important because it ultimately determines the growth of corporate profits. Stock prices typically fall before and at the beginning of a recession (and therefore earnings). Therefore, in the case of top-down asset allocation, faster economic growth is a positive factor for the stock market. Growth in the global economy is expected to slow slightly this year, especially in the United States, which continued to grow at surprisingly high rates last year. You can then look for regions with the best relative growth potential and strategically allocate your assets there. For example, the relative growth gap between fast-growing emerging markets and developed markets has narrowed in recent years, resulting in the underperformance of emerging market stocks. This growth gap is expected to widen again in the near future.

however, Really In the long run, demographic and productivity growth driven by technological development will play the biggest role in economic growth. Looking at these variables, the US appears to be in a strong position. Investors can do the same at the sector level. Where are profits growing fastest? Each sector increasingly has its own cycle. Cyclical sectors are still fully tied to the tides of the economy, but sectors such as semiconductors can move directly through the tides of the economy. I think IT (information technology) and related fields will be riding a wave this year. To increase long-term profitability, pay attention to social trends. In that case, IT stocks will still emerge, but the industrial sector will also be considered, where many solutions to the climate problem will emerge.

Interest level

The second most important factor is the interest rate component. The so-called risk-free interest rate is the reference point for all investments. In Europe, the benchmark is usually his 10-year yield on German government bonds. When the risk-free rate, or base rate, increases, the returns you seek from other (riskier) investments automatically increase as well. Therefore, low or declining interest rates typically support all asset classes. This revaluation affects government bonds most directly, with lower interest rates immediately leading to higher bond prices. The door appears to be open for interest rate cuts this year. In the most likely scenario, central banks are expected to lower policy rates based on slowing inflation. And long-term interest rates are already discounting this scenario, but I think they could go a little lower.

Therefore, the interest rate factor will be positive for financial markets going forward. Over the past two years, volatility in the government bond market has increased sharply. This increased volatility can last for a long time due to reasons such as geopolitical tensions, climate change, and demographic trends (aging populations lead to lower money supply). This means that bonds are now slightly riskier than in the past, even compared to other asset classes, and argues that they should be less heavily weighted in mixed portfolios. As mentioned earlier, interest rates are important for each asset class.

The relative importance of the interest rate factor to the price of the asset class decreases when the asset class is more influenced by the other three factors. Besides economic growth, there are valuations and sentiment, which we will discuss later. After government bonds, other bond categories such as investment grade corporate bonds and high-yield corporate bonds most closely approximate these other factors. The price of these bonds is determined by the risk-free interest rate plus a premium for credit risk, the so-called spread. Obviously, this is company-specific, but on average across categories, this spread changes with economic development, valuations, and sentiment. All four different factors influence each other. In particular, the relationship between interest rate factors and the next factor, valuation, is strong.

evaluation

A financial product valuation tells you how much you will pay for a stock, bond, or other product based on its underlying characteristics. For example, what multiple of earnings, cash flow, and book value do you pay for stocks? Or, for bonds, how much additional interest do you earn on average for a given credit risk? Stocks in general A useful valuation metric is the price-to-earnings ratio (PER). In other words, how many times earnings do you pay for a stock?Currently, it’s about 16.5x for global stocks. Is this high or low? Based on historical data, global equity valuations are just above the historical average of 16 times trailing 12-month earnings. In other words, the current valuation is neither cheap nor expensive. Figure 1 shows the evolution of price versus earnings over the past 30 years.

If you look one level down, you’ll see some interesting differences. US stock market valuations are around 20 times P/E, while European stock markets trade at 12 times P/E. The latter figure also applies to emerging market stock averages. Now, valuations and valuation differences are of little concern in the short term, but in the long term they affect expected returns. From that perspective, European stocks and emerging market stocks are relatively interesting. Looking at bonds, spreads for corporate bonds, high-yield bonds, and emerging market bonds are below their long-term averages. Therefore, high-risk bonds are well-valued. From that perspective, we should underweight them for now. But I don’t think you should. After all, there are still additional profits being made, and these particular companies’ balance sheets also look strong compared to their historical averages. In fact, the obvious alternative, the government bond balance sheet, appears vulnerable. After all, investing is a relative game.

Speaking of relativity, combining valuation and interest rates provides a more useful metric in the short term when determining the relative attractiveness of stocks and bonds. Calculating the inverse of the P/E ratio gives you the stock’s earnings yield. Comparing this income yield with the interest rate on government bonds gives you the so-called stock risk premium. Figure 2 shows the evolution of this equity risk premium. I took the average earnings yield of the world stock index minus the average government bond interest rate of the major blocks. This figure also hovers around the long-term average at 3.9%, so a neutral weighting between stocks and bonds seems justified in the short term.

emotions

Unlike valuation, the fourth factor is a short-term indicator. What I’m actually talking about is contrarian indicators. Because that’s what sentiment is. After all, bullish investors have probably already bought into the market and could be the next sellers. On the other hand, investors who say the investment environment is unfavorable probably don’t have a position themselves and are likely to be buyers in the market overall. There are several sentiment indicators, including the American Association of Individual Investors’ (AAII) famous “Bull Bear Survey” (AAII Investor Sentiment Survey). Additionally, some financial websites, such as CNN, have their own sentiment indicators. At the moment, these sentiment indicators are at high levels, indicating bullish investor sentiment. Emotional indicators are most effective in extreme cases. It is a reliable contrarian indicator, especially when sentiment is extremely bearish. One of my favorite charts combines sentiment with the returns of the S&P 500 (Standard & Poor’s 500) index with a one-month lag, as shown in Figure 3.

Figure 3 shows that during periods of negative sentiment, the stock market performs well in the next month. As mentioned earlier, emotions can change quickly. Therefore, sentiment (and other factors) may have changed by the time this article was published.

conclusion

These four factors can be used to form opinions about asset allocation at various levels. At the first level, the two major asset classes, bonds and stocks, look slightly different based on these characteristics. In that case, we would expect a positive return in both categories this year, so a neutral weight would be appropriate. Over the long term, we expect higher volatility in bonds, which justifies an underweight in bonds relative to equities. At the second level, from a regional perspective, the United States still appears to be the place to be. Slightly longer term, I see valuations playing a big role and there are good opportunities in emerging markets. Looking at sectors, sectors similar to IT are always attractive. And last but not least, let’s not forget the companies that will benefit from the energy transition.