Quarterly Tactical Asset Allocation Changes

Macro Tactical Asset Allocation Recommendations
Investment Themes (January 2002)

Portfolio asset allocation accounts for over 90% of returns over time. Fragasso Financial Advisors recommends that all investment portfolios be complete and include a broad diversity of non-correlating and low correlating asset classes. Broad diversification across asset classes potentially improves the risk/return tradeoff of investment portfolios over time.

Investors' personal goals, objectives and circumstances should dictate the investment portfolio balance between equity and fixed-income investments.

Within the equity and fixed-income markets, asset classes are selected in order to maximize the benefits of diversification. The recommended allocations are selected by studying the historical relationship among all asset classes through a cross-section of favorable and unfavorable market conditions alike.

As market conditions change, Fragasso Financial Advisors's investment committee will tactically adjust the asset allocation in order to take advantage of potential opportunities in the market place. Tactical asset allocation shifts will not exceed 5% changes from the recommended neutral position.

In the paragraphs below, we are outlining the tactical asset allocation changes as of January 2002.

1. Large Cap Stocksreduce allocation

Returns from large-cap stocks are unlikely to appreciably exceed high single-digit returns over the next 3 years.

Large-cap stock returns are a factor of 3 variables:

A. Cost of capital
B. Earnings + Earnings growth
C. Multiple P/E expansion

1. Cost of capital - Likely to increase, putting pressure on stock prices
   At 4.5%, the 10-year Treasury is at a historically low level. Yields have not been at such low levels since the October 1998 financial crisis and the early 1960s. This risk free rate is likely to increase over the next 3 years increasing the cost of capital.
   
   
2. Earnings growth - Likely to stay below long-term average
   Over the long run, real earnings growth has averaged about 2%. Assuming this trend continues and inflation remains around 2%, nominal earnings growth is only 4%, well below a long-term average of over 6%.
   
   
3. Multiple P/E expansion - Unknown
   Only if investors' sentiment improves, multiples will be able to increase from current levels to higher multiples than we would expect based on the historical average relationship between earnings and interest rates.

Conclusion: With 2 out of 3 variables possibly working against large cap stocks (and 1 unknown), we recommend a relative underweight in large cap stocks.

2. Small Cap Stocksincrease allocation

Small Cap Stocks traditionally lead markets in times of economic recovery.

Small-cap stocks have outperformed over the last couple of years, but they remain good relative values. With the economy clearly in recession, it makes sense to begin looking towards the cyclical recovery.

Small-caps almost always outperform in recoveries because their earnings tend to be more economically sensitive than the earnings of larger companies.

Conclusion: Smaller companies could generate higher returns, than large companies over the next few years, on average. We recommend increasing mid-cap exposure (which also has the potential to do better than large-caps) as well as dedicated small-cap exposure.

3. International Stocksmaintain neutral allocation

The correlation between domestic and developed markets foreign stocks has increased as economies are becoming more inter-dependent. Excess return could still be gained from foreign stocks if US dollar depreciates against foreign currencies. This is a likely scenario given the current imbalance of purchasing power parity and the long run dollar appreciation over the past years.

Conclusion: Maintain international allocation neutral, concentrate in funds that do not hedge currency. Diversify by style, economic sectors, geographic exposure and market capitalization.

4. Value vs. Growthmaintain neutral allocation

Based on historical frame-of-reference large value stocks are no longer a better relative value than growth stocks.

Large stocks have strongly out-performed their growth counterparts over the past 18¸ months. It is still possible for value stocks to continue outperforming to the point of becoming expensive relative to growth. This would happen if investors "chase performance" and value stocks become the target of investors' latest "momentum play".

In a market where neither growth nor value is a clear favorite, we should maintain a neutral posture between growth and value, as well as allowing for eclectic, not style-box constrained managers.

Conclusion: Maintain an equal balance of growth and value stocks. Allow for managers who view themselves as stock pickers first and follow a consistent discipline.

5. Real Estate Investment Trusts (REITs)add allocation

REITs offer a steady stream of income, some appreciation potential and increased diversification to an investment portfolio.

REITs have performed very well over the past two years. They could still represent good value relative to large stocks and high quality bonds. With a relatively steady average dividend yield of 7.6% that grows over time, REITs remain a good value relative to other financial assets.

REITs' upside is constrained by their relationship to underlying property values. During periods of economic recession REITs sell at a slight discount to net asset value. In healthier economic environments they can sell at a slight premium to net asset value. Additionally, some additional price expansion could occur over time through growth in cash flows and dividends.

Conclusion: REITs benefit from high dividends and moderate price expansion (assumed to be around inflation rates). This combination makes double-digit returns over the next several years realistic. We should add high quality, well-diversified REITs to portfolios.

6. High-quality bondsReduce exposure

With 10-year Treasury yields around 4.5% and investment-grade corporate bond yields at less than 6%, total returns (interest plus price appreciation) from bonds are unlikely to exceed mid-single digits over the next three years.

The only way total returns can materially exceed the current yield levels (4 - 6%) is if yields fall further.

Falling yields are not likely and certainly the potential for a large decline is extremely small. It is more probable that yields will rise, as the economy recovers. High yields would result in total returns lower than current yield levels (bond prices would decline).

Conclusion: Probable total return for investment-grade bond returns is in the 5% range. We recommend reducing high quality bond exposure in portfolios.

7. High-yield bondsincrease exposure

The case for high-yield bonds is compelling:

1. Interest yields are around 13%.
   
   
2. While default rates in the high-yield sector remain high (Moody's forecasts that defaults will remain over 10% into the early part of 2002), the actual default-related losses translate to about 3%. Long-term default losses are historically much lower, annualizing less than 2%.
   
   
3. During economic slowdowns and recessions, investors shun credit risk and push the spread between Treasury note yields and low quality bond yields to very high levels. Today's spreads are around 9% (900 basis points). Historically, these spreads are close to all time highs. Average spreads over the last 15 years were around 4.5%, while during economic recoveries spreads usually fall to less than 4%.

Conclusion: Total return for high yield bonds over the next 3 years has the potential to average 12 to 15%, based on today's very high yields, potential for price appreciation and decline in default related losses as the economy recovers. While no returns can be guaranteed, we recommend increasing allocation to high yield bonds.

This article is for informational purposes only and not intended as financial advice. Consult your financial advisor to determine what is appropriate for your situation.
Past performance is no guarantee of future results.

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