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What Assets Should You Have In Your Moderate Portfolio?

With flat to slightly negative returns, one could make the case that the static Ibbotson model for diversification is working just fine. On the other hand, the more that one has minimized the downside risk of investment canaries in the financial mines, the more one has been able to relax. Based on the evidence, moderate growth investors who choose an allocation of 60% in large-cap U.S. stocks and 40% investment grade U.S. bonds are likely to outperform the static Ibbotson model in the near-term. If market internals continue to deteriorate and if the macro-economic backdrop continues to weaken, a tactical asset allocation decision to reduce the risk of exposure to extremely overpriced U.S. stocks may be called for. Ibbotson Associates provides asset allocation guidelines that span the risk spectrum from conservative to aggressive. The moderate portfolio consists of roughly 42% in U.S. Stock, 18% in Non-U.S. Stock, 35% Fixed Income and 5% in Cash. It follows that the static Ibbotson model might employ the following ETFs to achieve its moderate growth and income aim: With flat to slightly negative returns, one could make the case that diversification is working just fine. On the other hand, the more that one has minimized the downside risk of investment canaries in the financial mines – high yield credit, emerging markets and smaller corporations – the more one has been able to relax. An allocation of 60% in large-cap U.S. stocks (NYSEARCA: SPY ) and 40% investment grade U.S. bonds (NYSEARCA: BND ) improved performance to 1.6% – a swing of 240 basis points. An argument in favor of diversification across asset class segments is that, if one holds recommended percentages for the next 20 years, recent underperformers will provide value down the road. Moreover, the combination of the above-mentioned asset types performed better than an ethnocentric large-cap-only allocation (60% S&P 500, 40% Barclays Aggregate Bond Index) over the previous 20 years. Here’s the problem: There are times when the breakdown in an asset grouping and/or an influential sector(s) of an economy is symptomatic of larger issues for market-based securities. For instance, the collapse of the banking system in 2008 had been telegraphed by financial stock woes nearly a year beforehand. The Financial Select Sector SPDR ETF (NYSEARCA: XLF ):S&P 500 SPDR Trust ETF ( SPY ) price ratio had been highlighting the rapid-fire demise of financial stocks relative to the broader benchmark. (Note: Back in 2007, “ex Financials” was the popular excuse offered to dismiss S&P 500 overvaluation; in 2015, many are using “ex Energy” to justify S&P 500 overvaluation.) There’s more. Even as SPY notched new record highs in October of 2007, other asset groupings did not recapture highs set in July of 2007. Small companies via the iShares Russell 2000 ETF (NYSEARCA: IWM ) did not make it back. In the fixed income space, preferred shares via the iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ) were weakening as well. In the last year of the previous bull market (2007), lightening up on smaller companies, higher-yielding preferred shares as well as the financial sector benefited investors. Here in 2015, lightening up on smaller company stock ( IWM ), foreign developed stock (NYSEARCA: EFA ), emerging markets (NYSEARCA: VWO ) and high yield bonds (NYSEARCA: HYG ) has also been beneficial. For one thing, each of these asset types sits below long-term 200-day averages – a bearish sign for these asset classifications. Secondly, even when one excludes energy from the high yield bond picture, “ex Energy” spreads have been diverging from the S&P 500 throughout the year. Based on the evidence, moderate growth investors who choose an allocation of 60% in large-cap U.S. stocks and 40% investment grade U.S. bonds are likely to outperform the static Ibbotson model in the near-term. One might consider spreading the large-cap exposure across several ETFs such as the iShares Core S&P 500 ETF (NYSEARCA: IVV ), the iShares S&P 100 ETF (NYSEARCA: OEF ), the Technology Select Sector SPDR ETF (NYSEARCA: XLK ), the iShares Russell 1000 Growth ETF (NYSEARCA: IWF ) and iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ). I have had virtually no allocation to small caps, high yield bonds or emerging market stocks during this late-stage bull market. All of those areas remain mired in long-term technical downtrends. In addition, I have only 25% allocated to investment grade bonds with another 15% in cash/cash equivalents. If market internals continue to deteriorate and if the macro-economic backdrop continues to weaken , a tactical asset allocation decision to reduce the risk of exposure to extremely overpriced U.S. stocks may be called for. Make no mistake about it… large-cap U.S. stocks are overpriced. Year-over-year, corporate earnings have fallen from a height of $106 on 9/30/2014 for the S&P 500 to the most recent estimate just shy of $91 (October 2015). That is a decline of approximately 14%. The earnings contraction over multiple quarters with the TTM P/E Ratio at 22.7 is well above the average since 1870 of 16.6. For those who would rather embrace Forward P/Es, Birinyi Associates at WSJ.com estimates a value of 17.4. This implies that $91 is going to be $121 in the next 12 months. Short of a miraculous revival in energy demand, 33% earnings growth is not particularly plausible. Even a forward P/E of 17.4 is 25% higher than the 35-year average forward P/E of 13. Overvaluation by itself is not a reason to reduce exposure to large caps. A late-stage bull market could continue for several more years; highly priced can become exorbitant. That said, if an economic slowdown becomes an economic standstill, and if the number of large company stocks holding up the market-cap weighted indexes further retrenches, reducing one’s overall equity profile and raising one’s cash level is sensible. Keep in mind, positions that haven’t been working (e.g., high yield bonds, small caps, emerging markets, etc.) will probably cause even greater pain when the market falls. It is critical to keep losses small. Similarly, it is constructive to exercise a methodical approach to raising cash as a late stage bull market carries on. Having some cash available is the way to purchase investments at a better price in the future. Indeed, there’s a reason that one of the premier rules for investing rule is “Sell High, Buy Low.” For Gary’s latest podcast, click here . Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Small-Cap Stocks Are Ready To Rumble

Summary The backdrop for small-capitalization stocks looks compelling right now. A strong seasonal pattern for the small-cap sector is at hand. Small-caps tend to do most of their business in the US and should benefit from the improving US economy. The first half of December is historically weak performance-wise; mid-December is the time to accumulate. During times of stronger economic growth and rising interest rates, small-capitalization stocks have outperformed their large-cap counterparts. Add to the mix an approaching strong seasonal pattern, and you have the recipe for small-cap outperformance. The small-cap sector of the market will likely post a year-end rally and outperform large-caps over the next six months, if history is any guide. Small-caps have actually trounced large-caps by about 7% this year until they peaked on June 23rd of this year. Since then, large-caps have “turned the tables”, with the S&P 500 ahead by approximately 4% year-to-date. However, it’s time to overweight small-caps in your portfolio as history clearly favors stocks of small companies at this juncture in time. Much has been written over the years confirming the seasonal tendency for small-caps to outperform from January to June. Let’s take a look at a chart, which illustrates the seasonal pattern: (click to enlarge) Source: Jeffrey A. Hirsch, Stock Trader’s Almanac When the line on the chart is descending, large-caps are outperforming small-caps; when the line on the chart is rising, small-caps are moving up faster than large-caps. Based on this strong historical seasonal pattern, it may be prudent to trim your exposure to large-cap stocks and overweight small-caps for the next six months or so. Smaller companies tend to do most of their business within the U.S. and should benefit particularly from the modestly improving U.S. economy. With all the tax-loss harvesting going on this month, mid-December would be an appropriate time to begin buying the sector. There are a few ways to potentially capture the small-cap seasonal phenomenon. The Vanguard Small-Cap ETF (NYSEARCA: VB ) is a solid choice with the lowest expense ratio in the space, at just 0.09%. The SPDR S&P 600 Small Cap ETF (NYSEARCA: SLY ) is limited to just 600 or so small company stocks. The selection universe for this fund includes all U.S. common equities listed on the NYSE, NASDAQ Global Select Market, NASDAQ Select Market and NASDAQ Capital Market with market capitalizations between $250 million and $1.2 billion. The iShares Core S&P SmallCap 600 ETF (NYSEARCA: IJR ) is an ETF which offers inexpensive, superior performance. Its expense ratio is just 0.12%. If you’re looking for a more widely diversified fund spread across sectors and the growth-value spectrum, the iShares Russell 2000 ETF (NYSEARCA: IWM ) fits the bill. It’s the largest ETF in the small-cap sector and carries an expense ratio of 0.20%. Lastly, the PowerShares DWA SmallCap Momentum ETF (NYSEARCA: DWAS ) is an interesting choice. Dorsey Wright & Associates, an internationally recognized firm for its work in tactical asset allocation and technical analysis, selects securities pursuant to its proprietary selection methodology, which is designed to identify securities that demonstrate powerful relative strength characteristics. DWA has an excellent track record and a wide following. Its expense ratio is the highest of the group, coming in at 0.60%. Year-to-date, IJR, DWAS and SLY have performed similarly and all three are outperforming VB by approximately +1.97% and IWM by +2.33%. (click to enlarge) Here is a longer-term chart going back to June of 2012: (click to enlarge) IJR and DWAS, again, have performed similarly and have outperformed VB by +5.86%, SLY by +8.27% and IWM by +8.78%, respectively. IJR has edged out most of the other ETFs over various time periods and combined with its very low expense ratio, makes it a very attractive choice in the small-cap space. Conclusion The outlook for small-cap stocks looks favorable right now. One of the most important factors powering the performance of small-cap stocks is economic growth. Studies involving past rates of return have shown that during times of improving economic conditions and rising interest rates, small-cap stocks tend to outperform large-caps. One possible reason for the strong performance of small-caps relative to large-caps in rising rate environments is that rates tend to go up in response to better economic conditions, which tend to provide a positive backdrop for small-cap companies. We would use the weakness we’re seeing in early December to accumulate small-caps via low-cost ETFs through year-end.

How To Find The Best Sector ETFs: Q4’15

Summary The large number of ETFs hurts investors more than it helps as too many options become paralyzing. Performance of an ETFs holdings are equal to the performance of an ETF. Our coverage of ETFs leverages the diligence we do on each stock by rating ETFs based on the aggregated ratings of their holdings. Finding the best ETFs is an increasingly difficult task in a world with so many to choose from. How can you pick with so many choices available? Don’t Trust ETF Labels There are at least 44 different Financials ETFs and at least 196 ETFs across all sectors. Do investors need 19+ choices on average per sector? How different can the ETFs be? Those Financials ETFs are very different. With anywhere from 24 to 561 holdings, many of these Financials ETFs have drastically different portfolios, creating drastically different investment implications. The same is true for the ETFs in any other sector, as each offers a very different mix of good and bad stocks. Consumer Staples ranks first for stock selection. Energy ranks last. Details on the Best & Worst ETFs in each sector are here . A Recipe for Paralysis By Analysis We firmly believe ETFs for a given sector should not all be that different. We think the large number of Financials (or any other) sector ETFs hurts investors more than it helps because too many options can be paralyzing. It is simply not possible for the majority of investors to properly assess the quality of so many ETFs. Analyzing ETFs, done with the proper diligence, is far more difficult than analyzing stocks because it means analyzing all the stocks within each ETF. As stated above, that can be as many as 561 stocks, and sometimes even more, for one ETF. Any investor worth his salt recognizes that analyzing the holdings of an ETF is critical to finding the best ETF. Figure 1 shows our top rated ETF for each sector. Figure 1: The Best ETF in Each Sector (click to enlarge) Sources: New Constructs, LLC and company filings How to Avoid “The Danger Within” Why do you need to know the holdings of ETFs before you buy? You need to be sure you do not buy an ETF that might blow up. Buying an ETF without analyzing its holdings is like buying a stock without analyzing its business and finances. No matter how cheap, if it holds bad stocks, the ETF’s performance will be bad. Don’t just take my word for it; see what Barron’s says on this matter. PERFORMANCE OF ETF’S HOLDINGS = PERFORMANCE OF ETF If Only Investors Could Find Funds Rated by Their Holdings The PowerShares KBW Property & Casualty Insurance Portfolio ETF (NYSEARCA: KBWP ) is the top-rated Financials ETF and the overall best ETF of the 196 sector ETFs that we cover. The worst ETF in Figure 1 is the Fidelity Covington MSCI Utilities Index (NYSEARCA: FUTY ), which gets a Dangerous rating. One would think ETF providers could do better for this sector. Disclosure: David Trainer and Blaine Skaggs receive no compensation to write about any specific stock, sector, or theme.