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My 2006 plan: Think Japan, fight inflation
Im tossing out some old names and bringing promising new funds into my ETF portfolio. I expect inflation at home and better performance abroad.
By Timothy Middleton
This has been a bad year for buy-and-hold investors, with the average domestic stock ahead a little less than 6%, about half its historic average, and bonds up less than 2%, likewise a poor return by normal standards.
My market-timing model portfolio of exchange-traded funds hasnt set the world on fire, but it did manage a return of 8.4% this year, as of Dec. 20. Thats better than the 5.3% return of the average moderate-asset allocation fund in the Morningstar database. My portfolio would fit into that category if it were a mutual fund.
In the fourth quarter, the portfolio advanced 3.2%, compared with a 3.6% rise in S&P Depositary Receipts (SPY, news, msgs), the ETF that is my proxy for the market.
Since November 2003, when I launched the portfolio, it has advanced 25.7%, or 12.5% on an annualized basis. (All data are as of Dec. 20.)
Related news and commentary on MSN Money
But the path so far hasnt been very difficult compared with what lies ahead. The middle year of the four-year presidential election cycle doesnt always finish down, but it is usually when the market reaches its lowest point of that four-year cycle.
Out go the large caps
The biggest worry I have for next year is sometime in March or maybe April, says Greg Church, an investment adviser in Yardley, Pa. Ive got to think Wall Street will be looking ahead to the midterm elections, and the possibility Republicans could lose one or both (chambers of Congress.) That would be a negative factor on the market.
So, as I adjust my model for the coming year, Im trimming exposure to domestic stocks and boosting exposure in Japan, which I expect to do very well next year. (See "Japan's latest rebound is for real.")
On the fixed-income side, Im adding some protection against inflation, which perked up substantially this year.
Here is how the portfolio finished this year and how it will begin the next.
| Middletons ETF portfolio, fourth quarter 2005 | | Exchange-traded fund | 4th qtr.
performance | 4th qtr.
holdings | 1st qtr.
holdings | | Equities | N/A | 82% | 72% | | iShares Dow Jones Select Dividend (DVY, news, msgs) | - 0.2% | 10% | 0% | | iShares GS Natural Resources (IGE, news, msgs) | - 0.8% | 11% | 11% | | iShares MSCI EAFE Fund (EFA, news, msgs) | 5.7% | 15% | 15% | | iShares Russell 200 Index (IWM, news, msgs) | 2.3% | 15% | 12.5% | | Nasdaq-100 Trust (QQQQ, news, msgs) | 5.2% | 15% | 12.5% | | S&P Dep Receipts (SPY, news, msgs) | 3.6% | 10% | 10% | | iShares MSCI E.M.I.F (EEM, news, msgs) | 6.7% | 6% | 6% | | iShares MSCI Japan Index (EWJ, news, msgs) | 14.7% | 0% | 5% | | Fixed income | N/A | 18% | 28% | | iShares LEH AGG FD (AGG, news, msgs) | - 0.2% | 10% | 5% | | iShares CS RTY MAJ IN (ICF, news, msgs) | 3.3% | 6% | 6% | | SLM CPI-Linked Notes (OSM, news, msgs) | 5.8% | 0% | 5% | | Cash | .25% | $4,050* | $15,638** | | Totals | N/A | $121,826 | $125,748 |
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Notes: Data as of 12/20/2005. Totals do not add up due to rounding. *3.3% of the portfolio.
**12.4% of the portfolio.
Sources: MSN Money, Morningstar Inc.
Here's what Im doing, and why:
Hello and goodbye
Bye, bye, iShares Dow Jones Select Dividend (DVY, news, msgs). These bargain big-capitalization stocks (their relatively low share prices produce their relatively high dividends) were a stalwart of the portfolio until last summer. I slashed them to 10% of the portfolio from 18% when the fourth quarter began. Now Im cutting back on big-cap stocks, so out they go altogether.
Im trimming back my exposure to small-cap stocks via iShares Russell 2000 Index (IWM, news, msgs) and to high-growth stocks via the Nasdaq-100 Trust (QQQQ, news, msgs), but the portfolio remains overweight those two arenas and underweight in domestic big caps. I had built small caps and technology up in the fourth quarter. Small caps disappointed, but the Nasdaq tracking stock was my best-performing domestic asset in the quarter.
Im holding onto iShares GS Natural Resources (IGE, news, msgs) because I think energy and commodities will remain a growth area for the foreseeable future.
On the international side, I am leaving my exposure to diversified, developed and emerging markets unchanged, and adding a 5% stake in iShares MSCI Japan Index (EWJ, news, msgs). That was the hottest developed-market bourse this quarter, and I expect it to retain that momentum in the new year.
I will now have 26% of total assets -- a third of the portfolio's equity assets -- outside the United States.
Changing fixed-income horses
On the fixed income side, I am halving my holding of the broad domestic bond market, iShares Lehman Aggregate Fund (AGG, news, msgs), because the economy is strong enough to lead the Federal Reserve to continue ratcheting up interest rates. I think one or two further quarter-point increases are built into todays bond prices, but I think a third is at least possible, which would weaken them.
I am switching that money into SLM CPI-Linked Notes (OSM, news, msgs). These are not an exchange-traded fund, but there is no ETF that accomplishes what I want, and these notes are similar to ETFs in that they trade like stocks, throughout the day.
The only inflation-resistant ETF is iShares Lehman TIPS (TIP, news, msgs), and it declined 1.6% in the fourth quarter. Thats because Treasury Inflation Protected Securities have long maturities, meaning they are hypersensitive to interest rates.
The SLM notes, which surged nearly 6% in the quarter, are issued by what used to be called Sallie Mae, the student-loan agency, and have much shorter maturities than TIPS. They also adjust for inflation immediately, rather than deferring the adjustment until maturity as TIPS do. They were by far the best-performing fixed-income security in the fourth quarter, and I dont think inflation is going straight back to bed. I suspect higher energy prices are going to begin to push up prices throughout the economy.
I am holding 12% of the portfolios assets as cash. Most portfolio-management software, including our own at MSN, does not recognize cash as an investment, but it is, especially when its paying 4%, as it is now. By the end of the first quarter I expect the best money market funds to be yielding 4.25%.
As for my concerns about the election cycle: Most investors regard these market patterns as voodoo. But this year, for example, Morgan Stanley technical analyst Rick Bensignor expects the same pattern for wholly different reasons, having to do with support and resistance in the S&P 500 Index ($INX, news, msgs).
We think the S&P will likely hit 1,295 within the next few months, with an outside shot of seeing 1,345 by late 1Q/early 2Q 2006, he wrote to clients this month. We dont, however, think the market gets much above that before a significant decline appears that could take the index down over 15% from its peak in what could be a very nasty middle part of the year.
(The S&P 500 was around 1,267 at press time.)
I am more comfortable erring on the side of caution than aggression. Politics are already unsettling civil society. Leakage into the financial sphere is likely, and likely to be more bad than good.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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