Positioning for 2012: Don't Underweight Stocks

For the last three years I have participated in a special interview series at Seeking Alpha.  Editor Jonathan Liss comes up with questions that suit both the times and reader interest.  I think that readers may find the discussion to be interesting, and may wish to add some comments or questions of their own.

The interview was originally published a series of articles explaining my reasoning.

I think that the market reflects a high degree of pessimism. You can protect assets by reducing position sizes, which I have done. Buying puts is too expensive. You could do some more complicated put strategies, but something like a “put diagonal” is not suitable for most investors.

SA: Do you buy into the argument that European equities are actually undervalued right now?

JM: One of my pet peeves is people who answer questions when they basically do not know. I have an honest answer. While I study the European situation carefully, I am not considering specific stocks there. There are many US companies that are undervalued because of Europe. I can get plenty of octane with much less risk buying JPM and CAT.

SA: How much exposure to emerging markets do you have both in terms of stocks and bonds? Are China, India or other major EMs better positioned to withstand a serious global economic downturn than the U.S.?

JM: Most people are surprised to learn that the US has actually fared better in recent years. It is possible to get a solid amount of foreign exposure via big US firms like CAT, MSFT, and ORCL (a recent disappointment, but still a great growth story).

SA: Let's move on to another potential event on investor minds: The Iran nuke situation and a potential Israeli, U.S. or global attack. How serious would such an event be to oil prices and subsequently, the global economy/exchanges? Is this something you're positioning for and if so, how?

JM: Great question! This is one of the big wild cards for 2012. Most people are bearish on energy because it fits the pessimistic view of the world. Many energy companies are extremely cheap on a P/E or cash flow basis. Owning some energy stocks will help if oil prices spike. I like Noble Energy (NE) among the drillers and Chevron (CVX) among the large integrated plays. There are many good choices in this sector. U.S. Market

SA: We are coming up on an election year. Will this be good or bad for markets? Are you positioning for different potential outcomes?

JM: Elections, political events, and the impact on stocks really hit my sweet spot. As a former public policy professor at a top university, I have studied the political side for decades. Since 1987, I have been a player on the financial side. It is so tempting!

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I would love to make a prediction, but it is too soon. My team is working on a generic Obama portfolio as well as a generic GOP portfolio. I will expand on this as soon as we learn more.

This is a typical area where people try to stake out positions too soon, with little information.

SA: Is the U.S. housing market still an issue, or not so much anymore? Will prices continue to fall? Do you have exposure to either REITs or residential real estate in client portfolios?

JM: I have no position at the moment, although our short-term models have been indicating good trades (three-week horizon) in these sectors. When the time comes, this will be one of our major profit sources. I am willing to miss the first part of the rebound in favor of more certainty. Bonds/Fixed Income

SA: Where do you see Treasury yields in 12 months? Are Treasuries worth buying at current (low) yields? For clients requiring income, where have you been turning in this low yield environment?

JM: This has been a great success story, but the end is near. I have two approaches for yield.

First, for clients that only need to preserve wealth (Congratulations!), I construct bond ladders. These include only investment grade bonds with a limit of seven years on maturity. If rates rise, we’ll be able to take advantage. If you have already achieved what you need, keep risk at a minimum!

For most clients I am using enhanced yield – a good dividend stock plus the sale of a call option. I do this with Abbot Labs (ABT), Johnson and Johnson (JNJ), as well as solid tech stocks like Intel (INTC) and Microsoft (MSFT). The combination of yield plus call premium is almost 10% per year after fees. This is working because of low stock prices and high volatility. It might not work in another year, but for the moment, let us take what the market is giving us!

This is a great method as long as you pick stocks that will hold value and monitor them carefully.

SA: What is the ideal asset allocation for someone with a long-term horizon (greater than a decade) and no need to touch their investments? Can investors continue to rely on stocks after the 'lost decade' we just experienced?

JM: I appreciate your desire to quantify this, but I am struggling since it is so far from my individual approach.

Let me try it a different way.

The single biggest mistake of the individual investor – right now – is underweighting stocks. This happens for several reasons:

Fear sells – in politics, advertising, and page views.

Individual investors always react to highly-publicized events because they do not understand how to determine what is already “in the market.”

It is a mistake to be “all-in” or “all-out.” This is not poker. Most people will never attain their investment goals if they do not have a rational strategy for when and how to buy stocks.

People underestimate the upside. We have just experienced a year with tremendous earnings growth and no movement in stock prices. The price/earnings ratio is back where it was at the market lows of 2009. If and when some of the worries are relieved, stocks can move to a more normal P/E multiple.

If the European concerns are addressed, people must understand the stocks could move much, much higher.

My advice? Based upon what I see in many interviews, most people should be nudging stock exposure a bit higher. It is possible to participate in the upside potential while keeping a rein on risk.

Disclosure Statement: NewArc’s five different programs are currently invested in all of the stocks and ETFs mentioned. The specific characteristics vary according to the investor.

Here is a good illustration. New investors do not go all-in on the first day – we look for good entry points. An investor in Great Stocks would own Apple tomorrow, since I think it is massively under-valued. An investor in the enhanced yield program would never own Apple.

To summarize, every stock mentioned is right for one of our programs. The individual investor must be cautious when reviewing market commentary like this. Everyone is different!

Written By: Jeff Miller