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November 22, 2013
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Favoring stocks amid a dull economic recovery
By: R. Samuel Fraundorf, CFA, President
Wilmington Trust Investment Advisors

Our Investment Strategy Team met this week and affirmed the weightings of our model asset allocation strategies.1 As depicted in Figure 1, we are overweighted, relative to our benchmarks, in equities. We are underweighted in fixed income securities—nominal bonds and cash equivalents combined. We are especially light on core bonds, such as U.S. Treasuries and investment-grade corporate and municipal debt. We continue to allocate to non-core bonds, such as speculative-grade floating-rate notes, and are overweighted in those assets by definition, because they are not included in our strategies' benchmarks. We retain our half-of-benchmark stakes—5% versus 10% in all strategies—in real assets, which include inflation-linked bonds and commodity- and real estate-related securities.

Figure 1
Our model asset allocation strategies' broad asset class weightings relative to our benchmarks' allocations, in percentage points

The length of the bars representing stocks and nominal bonds and cash equivalents reflects the varying amounts by which our model strategies are overweighted and underweighted, respectively, relative to their benchmarks. We maintain a variety of model strategies, to address the needs of aggressive to conservative investors. The diamond representing inflation hedges— inflation-linked bonds and commodity- and real estate-related securities—reflects the identical, 5- percentage-point underweight to that asset class across all models.

Why we are overweighted in stocks

  1. We expect the global economic recovery to continue, despite the slowdown in emerging-market growth rates.
    1. Europe's economy, though still weak, appears to be stabilizing.
    2. While it is growing slowly by historical norms, the U.S. economy is likely to continue expanding more quickly than most other developed economies.
    3. The rebound in the U.S. housing market, though it has slowed of late, has boosted our confidence in the U.S. recovery.
    4. We expect real (inflation-adjusted) U.S. economic growth to accelerate to 2.5% or better in 2014, as the effects of the federal spending sequester fade.
    5. The Federal Reserve is likely to remain accommodative well into 2015. Janet Yellen, current vice chairwoman of the Fed and presumptive successor to Ben Bernanke, has reinforced Bernanke's suggestions that the central bank's short-term interest rate target may remain near zero for some time after its $85-billion-per-month bond-buying program has drawn to a close. She appears willing to allow inflation to accelerate in an effort to boost the pace of job creation.
  2. We expect corporate earnings growth to continue to satisfy, though not overwhelm, investors.
    1. Our estimate of S&P 500 Index profits in 2014 is $116 per share, up from an estimated $109 per share this year. Our 2014 profit estimate is slightly conservative relative to the consensus forecasts of both top-down strategists and bottom-up company analysts ($118 and $122, respectively).
    2. We forecast that on September 30, 2014, the S&P 500 Index will be trading in a range of 1800–1920. The range reflects estimated price/expected earnings ratios of 15.0–16.0x and an earnings per share forecast of $119.50 for the 12 months ending September 30, 2015. The index closed today at 1805.
  3. When the Fed does begin to taper its bond purchases, we'd expect yields to rise further, further hurting bond prices.
    1. We expect interest rates—specifically, the yield of the 10-year U.S. Treasury note—to climb into the 3.0% range or higher by mid-2014, as the Fed begins to taper its asset purchases. The 10-year note yielded 2.8% at the close of trading today.

The big picture
The big picture is that we have been migrating toward more equity-centric portfolios, in keeping with our belief that the recovery would continue and because we recognized that bonds became riskier as their yields reached historic lows. Twelve months ago, the stock allocations of our model strategies either matched our benchmark allocations or were a percentage point or two higher. We were more overweighted in fixed income securities and had the same half-of-benchmark allocations to inflation hedges. Our migration over the last 12 months toward greater investment risk and opportunity—really, two sides of the same coin—coincided with a sharp rally in stock prices and a decline in bond prices, as interest rates rose. Our allocation to non-core bonds, especially speculative-grade floating-rate notes, has been intended to limit the price declines of diversified fixed income portfolios, relative to those fully invested in core bonds, as interest rates rose, as they have done since mid-2012.

As ever, we welcome your questions, and we thank you for investing with Wilmington Trust.

1 The construction of our model asset allocation strategies generally reflects a combination of asset-class valuations and momentum, overlaid by the judgment of our Investment Strategy Team. The extent to which—and speed with which—strategy-following client accounts reflect the Investment Strategy Team's models may vary, reflecting client-specific circumstances such as tax sensitivity, liquidity, and investment horizon.

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