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The U.S. market looks good to me
Despite the market's sell-off last week, I'm boosting my model ETF portfolio's exposure to U.S. stocks and bonds after a pretty good ride in the second quarter. Europe and Japan don't look as good.
By Timothy Middleton
The domestic stock market tried and failed to rally in the second quarter, in part a victim to higher energy prices. Domestic bonds did move up nicely in the period, however, thanks to declining inflation expectations. The dollar also pushed higher, sharply reducing profits from overseas.
The net effect was to leave my foreign-equity-heavy model portfolio of exchange-traded funds trailing its benchmark for the first time in six quarters. The 60% stock/40% bond Vanguard Balanced Index Fund (VBINX) trumped my gain of 1.9% with a 2.5% return.
Both of us beat the domestic stock market, which gained 1.7% in the second period.
(For production reasons, these data refer to the period between March 23 and June 24, when I closed the books for the first and second quarters, respectively.)
My only losing position was the iShares MSCI EAFE Index (EFA, news, msgs) fund, but it was a doozy. This measure of foreign developed equity markets declined 1.2% in the quarter, due entirely to the rallying dollar, and it represented nearly 20% of my assets.
I was hardly the only investor over-invested overseas. "We had been underweight the U.S. market," says Sarah Arkle, chief investment officer of Threadneedle Asset Management in London. "But there has been a tremendous convergence of valuations around the world, and we're now comfortable with the dollar, so there doesn't seem to be a clear reason to be underweight the United States."
So, like Threadneedle, I am boosting my allocation to U.S. equities, while cutting back my foreign exposure. On the fixed-income side, I'm slashing my cash hoard to buy both bonds and real estate investment trusts.
The net effects of my moves will be to boost domestic equities to 60% of the portfolio, from 48%; cut foreign equities to 15% of assets, from 25%; and boost bonds and real estate to 25% of assets, from 10%.
The portfolio's value stood at $116,114 on June 24. Here's how it finished the second quarter:
| Middleton's ETF portfolio | | Fund | Quantity* | June 24 close | % Gain | Market Value | | S&P SPDRS (SPY, news, msgs) | 97.000 | $118.98 | 1.66% | $11,541.06 | | iShares Dow Jones Select Dividend Index Fund (DVY, news, msgs) | 344.000 | $61.41 | 2.86% | $21,125.04 | | iShares MSCI-EAFE Index Fund (EFA, news, msgs) | 429.000 | $52.50 | -1.17% | $22,522.50 | | iShares Russell 2000 Fund (IWM, news, msgs) | 110.000 | $62.21 | 1.76% | $6,843.10 | | Nasdaq-100 Index Tracking Stock (QQQQ, news, msgs) | 170.000 | $36.97 | 1.89% | $6,284.90 | | iShares Goldman Sachs Natural Resources Index Fund (IGE, news, msgs) | 118.000 | $76.30 | 5.32% | $9,003.40 | | iShares MSCI Emerging Markets Index Fund (EEM, news, msgs) | 87.000 | $71.25 | 6.68% | $6,198.75 | | iShares Lehman Aggregate Bond Fund (AGG, news, msgs) | 113.000 | $103.32 | 2.48% | $11,675.16 | | Cash | | | | 20920.47 | | Totals | | | 1.90% | $116,114.38 |
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* Shares
Note: "Middleton's Portfolio" under ETFs at MSN Money showed a gain in the period of 1.64%, but that is incorrect because the software doesn't take the value of cash into account.
Source: MSN Money
How I'm implementing my changes
International equities: I'm very happy with emerging markets, my best performer in the second period with a gain of 6.7%, so I'll leave them untouched. But the iShares MSCI EAFE (EFA, news, msgs), which represents Euroland and Japan, dragged me down, and I don't expect the dollar to collapse in the third quarter. So, I'm cutting that position roughly in half, selling 200 shares and raising $10,490, after paying a $10 commission on the sale.
Related news and commentary on MSN Money
Domestic equities: As I wrote on May 3, the tech-heavy Nasdaq Composite ($COMPX) is due for some gains, and indeed it outperformed the Standard & Poor's 500 ($INX) in the second quarter. So did small-cap stocks. Result: I'm boosting my stake in each from 5.5% and 6.0%, respectively, to 10%. I'll purchase 73 shares of iShares Russell 2000 (IWM, news, msgs)and 141 shares of the Nasdaq 100 Tracking Stock (QQQQ, news, msgs). Together, that will cost me $9,774 after commissions.
Energy continues to greatly outperform the market, and I expect that to continue, so I'm increasing that position to 10% of assets, from 7.7%, by purchasing 34 shares of iShares Goldman Sachs Natural Resources (IGE, news, msgs). That will cost me $2,854. At this point my total cash, including that I already had and what I raised from the sale of EAFE Index is $18,782.
I'll hold my big-cap positions in S&P Spiders (SPY, news, msgs) and the Dow Jones Select Dividend Index Fund (DVY, news, msgs), which account for about half of my domestic stocks. As I wrote on May 31, I think big-caps have an especially rosy future.
Fixed income: Investment-grade bonds performed beautifully in the second period, as the market became increasingly less worried about inflation and more confident the Federal Reserve will soon stop tightening credit.
"We think ultimately that disinflation triumphs over reflation," says William Gross, manager of Pimco Total Return (PTTRX), the world's largest bond fund. "We see the 10-year Treasury trading in a zone of 3.0% to 4.5%" over the next three to five years. It currently yields just under 4.0%.
The best way to capitalize on that outcome, Gross says, is to extend the average maturity of a bond portfolio, because longer-term bonds are more sensitive to rates than shorter maturities. In bond-speak, this means extending duration, which is the mathematical link between maturity and rates.
My key bond holding, iShares Lehman Aggregate Bond (AGG, news, msgs), has a duration of 4.6 years. Gross says Pimco, the nation's biggest bond shop, is extending duration by six months. To do the equivalent, I am raising Lehman Aggregate to 15% of assets, from 10%, and adding 5% of iShares Lehman 7-10 Year Treasury Bond Fund (IEF, news, msgs), which has a duration of 6.6 years. The blend has a duration of 5.1 years -- just the half-year extension I'm seeking.
Note: Last year when I wanted to extend duration I used an ETF that owns Treasury Inflation Protected Securities. In the kind of low-inflation world Gross expects, TIPS would perform poorly compared with conventional Treasurys, so I'm avoiding TIPS.
To accomplish these goals, I'll buy 58 shares of Lehman Aggregate and 68 shares of Lehman 7-10 Year Treasury, which closed last Friday at $86.99. Together, this will absorb $11,928 of my cash, after commissions.
Also, I'm going to restore iShares Cohen & Steers Realty Majors Index Fund (ICF, news, msgs) to the portfolio, in the amount of 5% of assets. I put forth my rationale in my June 14 column; I'll buy 97 shares of this fund for $6,849, leaving $5 in cash on hand.
The effect of my changes is to accept significantly greater risk than I was carrying in the second quarter. I'm comfortable with that because the next market-damaging event I can foresee, a recession, isn't yet on the horizon.
A turndown is probably approaching, however; the length of the current economic expansion is about the post-war average. So I suspect bonds are going to look even more attractive three months from now than they are at present. But in the meantime I think stocks are set up for a decent summer.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: Vanguard Balanced Index Fund. Also, he is the author of "The Bond King: Investment Secrets from Pimco's Bill Gross" (John Wiley & Sons, 2004).
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