A portfolio for 2014

The US government is open for business once again after giving employees a two-week paid vacation and the debt ceiling has been temporarily raised. Both of these will come up for further review at the beginning of next year because, in its typical fashion, What is more troubling is the third-quarter earnings season results so far. With half of the Standard & Poor’s 500 companies having reported, almost 70 per cent are “beating” their earnings forecasts; however, the estimates had been revised downward continuously as we moved closer to the reporting date. There have also been some notable disappointments like IBM, McDonald’s and Caterpillar. What’s more, companies that do provide guidance to analysts are encouraging them to lower their estimates. Revenues have consistently risen much more slowly than earnings, which could be a profit warning for 2014. That’s disappointing in an economy where the Federal Reserve is providing a trillion dollars of monetary stimulus this year.

In 200,8 the total balance sheet of the Fed was $1 trillion and Treasuries represented less than 10 per cent of it. Today the Fed balance sheet is about $3.5 trillion and Treasuries account for about 25 per cent. Fed Chairman Bernanke was beginning to feel a little uneasy about the amount of US government securities on his balance sheet in May and that’s why he hinted at tapering. In June he must have had a premonition about the looming budget and debt ceiling problems and pulled away from tapering talk. Those concerns also may have been one reason why he decided not to taper in September. Another was the turbulence in the bond and mortgage market caused by the suggestion of tapering itself. Now any reduction in the monetary stimulus program has been deferred to 2014 when a new Fed chairman, Janet Yellen, will be in charge. She is likely to be as accommodative as Bernanke or more so.

Perhaps the most powerful force driving stock prices higher around the world on an almost daily basis is the fact that valuations are not excessive. On an earnings estimate for 2014 of $115, the Standard & Poor’s 500 is only selling at a little over 15 times earnings, which would be considered fair value on an historical basis. This valuation is a long way from the overvalued levels of 1999 and even 2007. An analysis by International Strategy & Investment (ISI) shows that if profit margins hold at present levels, revenue growth will have to be 5 per cent for the S&P 500 earnings to reach $115. This assumes a 1.5 per cent share buyback program for companies in the index.

In this environment, what asset allocation makes sense for institutional investors? While the total return for the S&P 500 was more than 16 per cent in 2012 and has been 23 per cent so far in 2013, I still believe there is further upside ahead, but a temporary correction from an overbought condition could occur at any time.

Two years ago I suggested a “radical” asset allocation for institutional investors to take advantage of the opportunities I saw ahead. The portfolio was designed to produce a high-single-digit return over a full market cycle. I have made some changes over the past 24 months and am making further adjustments now. I explained that this portfolio would be more volatile and less liquid than the asset allocation structure most institutions were used to, but I thought the long-term returns would justify these differences.

I continue to have a 10% position in high-quality global multinationals. These stocks have generally done well in this bull market, but they are not overvalued and continue to provide a reasonable yield with moderate earnings growth. Many of these companies are based in the United States. I also have a 10 per cent position in small and medium capitalization American companies.

I have a 10 per cent position in European stocks. Europe pulled out of its recession in 2009, but slipped back into one over the last two years. I believe investors will see modest growth in the region in 2014 and valuations are reasonable. I also have a 5 per cent position in Japan. I expect further appreciation in the Nikkei 225 from present levels based on improving fundamentals. Finally I have a 10 per cent position in emerging markets. This has been a disappointing category over the past two years as these economies have slowed. Growth is still greater than in the developed world, but the equity markets for most emerging countries have been poor. Valuations are very reasonable, profits are growing and I think we will see better performance in 2014. The five positions outlined so far represent 45 per cent of the total and are the long-only base of the portfolio.

I continue to think that institutional portfolios will benefit from a commitment to alternative investments. I have a 10 per cent position in hedge funds because I have seen them provide strong risk-adjusted returns over a full market cycle. I have a 10 per cent position in private equity because there will be a number of high-return opportunities in the years ahead as companies sell off divisions to rationalise their strategic operating structure. I believe leveraged buyouts will play a smaller role than they have in the past years. A private equity firm can be patient in waiting for opportunities which will benefit from improved management and adequate financing. Superior returns will compensate investors for the lack of liquidity.

Overall I have made 25 percentage points of changes in the portfolio. I established three new categories, long-only United States and long-only Europe at 10 per cent each and long Japan at 5 per cent. To provide funds for these new positions I trimmed 5 per cent from emerging markets, 5 per cent from hedge funds, 5 per cent from real estate and 5 per cent from non-conventional high yield, and I eliminated the 5 per cent cash position. I know it is customary to maintain at least a small cash position in institutional portfolios, but a 5 per cent position will not provide much protection in a market downturn and the yield on cash today is negligible. The increase in the liquid long-only portion of the portfolio should provide whatever funds are needed for distributions or for investing in any exceptional opportunities that may develop. The alternative investments were reduced by 10% and the long-only investments were increased by 25 per cent. Now let’s see if the portfolio is properly structured for a more difficult 2014.

— Byron Wien is the vice chairman of Blackstone Advisory Partners LP