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ASSET
ALLOCATION STRATEGY FOR NEW FED CYCLE
Part 4: How Interest Rate Changes Effects
by Chris
Ciovacco
Ciovacco Capital Management, LLC
October 15, 2007
Part
1 | Part 2 | Part
3
Expanding
the Analysis to Other Asset Classes
In Part
III of this four-part series, I concluded the periods following the
first Fed rate cut in July 1995, September 1998, and January of 2001
were most similar to today's economic landscape. We can use the
information from Part
III as one of many factors when determining our asset
allocation for the coming year. The next logical step is to explore how
different asset classes performed relative to each other in each of the
three respective historical periods (1995-1996, 1998-1999, 2001-2002). I
used the historical performance of each asset class to construct asset
allocations which would have been prudent for each particular period.
The resulting three asset allocations can then be combined into one
allocation using the similarity weights found in Part
III, Table 3, column 2. If there is a 16.54% probability the next
year may look like 2001-2002, it makes sense to consider weighting
16.54% of your assets to an asset allocation which performed well under
those economic conditions. The same is true for the other two historical
periods. I have made these allocation calculations down to the last
penny, but the detail is not necessary to convey the results. The
specific results are not as important as the relative results, such as
gold stocks performed better than long-maturity U.S. Treasury bonds in
the year following the first Fed rate cut. Graph 1 illustrates the
similarity-weighed historical path of each asset class one year after
the first rate cut by combining weighted daily historical data from each
of the three periods.
Since history
never repeats itself in exactly the same way and understanding the
limitations of the above analysis, it is helpful to blend the historical
findings with information that can be gathered from the current
investment environment. I chose to use two additional methods of
exploring the relative attractiveness of various asset classes (NOT
included in Graph 1). The first was to use the model I previously
created based on the past 3-month, 6-month, and 1-year relative
performance of each asset class. This model uses history to produce
probabilistic outcomes for the next year. I also felt it was important
to get an early read on the market’s reaction to the recent .50% rate
cut. Therefore, I also included the relative performance of each asset
class from the close on September 17, 2007 (the day before the cut) to
September 26, 2007. You’ll notice in Graph 1, the leadership for the
year after a rate cut was established soon after the cut was announced
(based on the similarity-weighted average for the paths taken after the
cuts in 1995, 1998, and 2001). The final results are shown in Table 4.
Based on the blended relative rankings of the Fed analysis, the one-year
relative performance model, and the relative performance since the
September 18, 2007 rate cut, the green items in Table 4 appear the most
attractive for the next year, the items in yellow are moderately
attractive, and on a relative basis the items in red are the least
attractive. For example gold mining stocks ranked highly in all three
models. Therefore, from a risk-reward perspective they appear attractive
relative to our other investment options. Items in red have the least
favorable risk-reward profile for the next year based on the three
models.
Update As Of October
17, 2007: Table
4 was compiled using data as of September 26, 2007. The updated
composite rank as of October 17, 2007 is (1) Gold Stocks, (2) Emerging
Market Stocks, (3) Commodity Stocks, (4) Dividend Stocks, (5) Emerging
Market Bonds, (6) Gold & Silver, (7) Foreign Real Estate, (8)
Mid-Cap Stocks, (9) Hedged Stocks, (10) World Stocks, (11) World Bonds,
(12) Timber, (13) U.S. Real Estate, (14) Hedged Stock II, (15) U.S.
Short Bonds - TIPS, (16) U.S. Intermediate Bonds, (17) CDs - Money
Market, (18) U.S. Long Bonds. Use at your own risk.
What
does it all mean?
In a nutshell, investors
might consider, within the context of their individual needs and
risk-reward profile, reducing their exposure to the items in red (Table
4) and possibly increasing the exposure to the items in green. The
objective for most growth investors is not to eliminate the items in red
(Table 4) or to only invest in the items in green, but to use the
results as a guide to possibly make some “tweaks” to their asset
allocation.
To emphasize the
importance of maintaining the balance between risk of principal loss and
risk of purchasing power loss, I have included the annual inflation
rates from 1971 through 1981 in Table 5. I doubt many investors have
assumed in any financial projection we could experience an 11-year
period where the average annual inflation rate is 8.19%. Notice
inflation was somewhat tame, as the published figures show today, in
1971 and 1972. Annual inflation rates more than doubled in 1973 going on
to average 9.26% annually between 1973 and 1981.
ETF's which offer
exposure to the asset classes shown in Table 4 are IYR, RWR, ICF, RWX,
DRW, TLT, IEF, AWF, DVY, VDE, XLE, EFA, EEM, TIP, VBR, and CEF.
Full Disclosure:
The author and his clients have long positions in RWX, AWF, and CEF, as
well as long exposure to other pooled investments in all the asset
classes shown in Table 4.
© 2007
Chris Ciovacco
Editorial
Archive
Chris
Ciovacco is the Chief Investment Officer for Ciovacco Capital
Management, LLC.
More on the web at www.ciovaccocapital.com
All
material presented herein is believed to be reliable but we cannot
attest to its accuracy. Investment recommendations may change and
readers are urged to check with their investment counselors and tax
advisors before making any investment decisions. Opinions expressed in
these reports may change without prior notice. This memorandum is based
on information available to the public. No representation is made that
it is accurate or complete. This memorandum is not an offer to buy or
sell or a solicitation of an offer to buy or sell the securities
mentioned. The investments discussed or recommended in this report may
be unsuitable for investors depending on their specific investment
objectives and financial position. Past performance is not necessarily a
guide to future performance. The price or value of the investments to
which this report relates, either directly or indirectly, may fall or
rise against the interest of investors. All prices and yields contained
in this report are subject to change without notice. This information is
based on hypothetical assumptions and is intended for illustrative
purposes only. THERE ARE NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO
ACCURACY, COMPLETENESS, OR RESULTS OBTAINED FROM ANY INFORMATION
CONTAINED IN THIS ARTICLE. PAST PERFORMANCE DOES NOT GUARANTEE FUTURE
RESULTS.
CONTACT
INFORMATION
Chris Ciovacco, CIO
Ciovacco Capital Management, LLC
Atlanta, GA USA
Email l Website
The
opinions of FSU contributors do not necessarily reflect those of
Financial Sense.
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