Asset Allocation - Q3/14 Update
by Ryan Lewenza, CFA, CMT, Private Client Strategist, Raymond James
§ We remain constructive on equities given an improving North American economy, the prospect of stronger corporate earnings, and attractive valuations when compared to low-yielding bonds. Our base case view is that stocks will rise in line with their earnings growth over the next 12-18 months.
§ Equities are no longer cheap but they are not excessively expensive, in our opinion. Currently, the S&P/TSX is trading at 19.4x trailing earnings and 2x price-to-book (P/B), which equates to just a 2% premium to their long-term averages. While equities are trading at modest valuations premiums to their long-term average it is important to emphasize that equities look attractive relative to bonds, which is an important factor in our overweight recommendation.
§ A key factor in our underweight recommendation in bonds is our belief that bond yields will move slowly higher as the economic recovery continues. Our proprietary bond forecasting model, which estimates “fair value” for the Government of Canada (GoC) 10-year yield, is currently suggesting fair value of 3.40% compared to its current level of 2.15%. Based on our expectations for economic growth and output from our bond model, we see the potential for the GoC 10-year yield to rise to a range of 3.25% to 3.50% in 2015. If correct, this would result in a 9% to 11% loss for the GoC benchmark 10-year bond over the next 15 months. As such, we recommend an underweight in government bonds.
§ We are currently underweight cash given low nominal yields and negative real yields, after adjusting for inflation. However, given the recent decline in the S&P/TSX, which did result in some intermediate term technical damage for the Canadian equity market, we are monitoring the equity markets closely and should we see important technical supports being broken, we would consider trimming our maximum overweight position in stocks and raise some cash. This would be more of a tactical move, as the long-term outlook for equities remains constructive, while cash yields remain very low.
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2014 Q3 Update - Asset Allocation
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