• Passive asset allocation strategies are straightforward and better than no strategy, but cannot be expected to yield first-class results.

• Through fact-based assessments of the investment environment and common sense, active asset allocation improves prospective returns while reducing risks.

• We assess risks and rewards for each asset class -equities, bonds, cash equivalents, as of mid 2018.

• We argue for allocation to equities and cash equivalents, avoiding bonds of intermediate and long-term maturity altogether.

Buying and holding wonderful businesses at compelling prices is one part of producing satisfactory financial results. And at Investment Works, we are giving you unprecedented transparency into the inner works of one of the most successful equity portfolios of the 2010s.

Asset allocation is the other part.

With proper execution, the combination of stock picking alpha and intelligent asset allocation maximizes prospective returns at the level of risk that the investor is willing to bear.

Individual investors are often led to passive asset allocation strategies such as:

• The 60/40 rule: 60% stocks, 40% bonds.

• The 100 minus your age rule: (100-age)% stocks, the rest bonds.

• The All Seasons Portfolio (suggested by Ray Dalio): 30% stocks, 40% long-term bonds, 15% intermediate bonds, 7.5% gold, and 7.5% commodities.

A balanced, passive asset allocation strategy is better, much better, than no strategy.

Just as buying and holding a passive index fund is much better than jumping in and out the wrong stocks at exactly the wrong time.

That's why a static policy of asset allocation to low-fee index funds is appropriate for most savers, who will be, and should be, content with getting average returns from their participation in the US economy.

But if you are reading these lines, chances are that you are willing to put the time and effort and seek the resources, to do better than average. Both in terms of returns and downside exposure.

Consistently beating the stock market is not easy. It takes informed, second-level, independent thinking, courage and discipline.

But the good news is that, when it comes to asset allocation, basic good old common sense can be enough to improve prospective returns and reduce risk relative to static rule-of-thumb recipes.

What we said in January

About six months ago, we warned about the risks of long-term bonds and recommended allocating funds to stocks and cash equivalents, avoiding longer-maturity debt instruments altogether.

Since then, stocks have returned some 4% (dividends included), 30-Year Bonds have lost 3.5% of their value (after half year of coupon payment accrual), and cash equivalents have yielded some 1.5%.

A 50% stock/50% cash portfolio would have returned 2.75%, compared to a meager 0.25% for a riskier 50% stock/50% bond portfolio.

Why did we recommend staying away from bonds? How did we see it coming?

Well, we didn't. We cannot forecast the future. Nobody can.

But we can asses the ongoing market environment and let that assessment inform our asset allocation decisions, rather than blindly sticking to a static asset allocation recipe.

Below, you find the main data required for that assessment, condensed in a single chart, as of June 22.

The chart has been taken from Investment Works Research, and we update it every half a year. Feel free to bookmark it for future reference.

Equity and corporate bond yields, GDP growth and US inflation figures, from 2006 to June 2018 (source: Investment Works Research)

On what follows, we estimate the average returns to be expected from each asset class, based on current valuations, GDP and earnings growth, and inflation expectations.

To be clear: we are not claiming the ability to forecast with any kind of accuracy asset class valuations a few months forward. We cannot do that, nor do we know of anybody who can.

Nonetheless, we believe that the exercise is worth the effort in that, from the outcome of the analysis and a little bit of common sense, it is possible to draw asset allocation directives likely to improve the risk-adjusted performance of a portfolio.

Returns to be expected from common stocks

Dividend and buyback yield

The most recent data on dividend and buyback yields for the companies in the S&P 500 (SPY) (IVV) (VOO) provided by S&P Dow Jones Indices is for the full year 2017. It put the dividend yield at 1.84% and the buyback yield at 2.28%, for a total distribution yield of 4.12%.

Several things have changed since then:

• The S&P 500 index has climbed 76 points, for a 2.9% gain.

• Real growth and inflation have increased nominal GDP by about 2.3% from December 2017 to end of June 2018.

• S&P 500 earnings have grown at an estimated rate of 19% YoY during Q1 and Q2 2018, boosted by tax reform.

We are trying to estimate the total distribution yield (dividends and buybacks) that a buyer of the S&P 500 at today's price can expect in the future. The gap between nominal GDP and corporate earnings growth was unusually large in 1H 2018 due to tax reform (2.3% vs. 19%).

In the upcoming quarters, competitive pressures in the good & services and labor markets will undoubtedly distribute the benefits from tax reform more evenly among stakeholders. Prices will be lower and wages higher than otherwise, partly closing the gap between GDP and corporate earnings growth.

For our purpose, we assume that S&P 500 earnings, and by extension shareholder distributions, will get a permanent 10% YoY boost as of end June 2018.

That puts the total shareholder distribution yield (from dividends and buybacks) as of June 2018 at 4.4% (4.12% *1.10 /1.029).

This figure excludes one-off special dividends and share repurchases funded by recent cash repatriation programs.

Earnings yield

At the same time, the S&P 500 TTM earnings yield sits at 4% (PE ratio of 25). A 10% earnings boost would bring the earnings yield to 4.4%, in line with the total shareholder distribution yield estimated before.

Expected return

US nominal GDP is expected to grow at an annual average rate of around 4% in the upcoming years (2% real GDP growth rate + 2% inflation).

Now, to materialize that GDP growth, corporate America is going to need to reinvest some cash. Let us be cautious and assume that of the 4.4% earnings yield, 3.5% can be sustainably distributed to shareholders, with the remaining 0.9% of market cap employed in funding that growth.

Assuming that equities are fairly priced today, the average annual returns to be expected from common stocks would be 7.5% (3.5% current distributable cash yield + 4% nominal growth), a bit below the average historical returns produced by US equities.

But current equity valuations are high by historical standards, so it may be prudent to reduce the annual stock return expectations for the upcoming years to the 6.5 to 7% range.

Summary

Substantial growth and interest-rate risk. Decent prospective returns (6.5 to 7.5% p.a.).

Returns to be expected from intermediate and long-term corporate bonds

As of May 2018, the 10-Year High-Quality Market (HQM) Corporate Bond Par Yield was 4.02%. The 25-Year one, 4.51%. (The HQM yield curve uses data from a set of high-quality corporate bonds rated AAA, AA, or A that accurately represent the high-quality corporate bond market.)

That is to say that if you buy and hold to maturity a basket of high-quality 10-year corporate bonds, you can obtain 4% annual returns. Extending maturity to 25 years increases annual return by 50 bps. That is of course in a best-case scenario of no credit default.

Meanwhile, the Fed is struggling to keep inflation at or below 2%, and nobody can tell for sure what is going to take, or whether it will be possible, to keep inflation at 2% in a post quantitative-easing era flooded with money.

But even if the Fed manages to maintain inflation at 2% (it was 2.4% YTD), that puts the best-case real return of 10-Year corporate bonds at 2%, and at 2.5% for 25-Year bonds.

That is low by historical standards. And it leaves you exposed to higher-than-usual inflation and interest rate risk.

Summary

Substantial interest rate and inflation risk. Low to medium prospective returns (4 to 4.5%).

Returns to be expected from cash equivalents

The third main asset class is cash equivalents, which includes money markets and U.S. Treasury bills.

As of end June 2018, 1-month treasuries yield 1.85% and 1 year treasuries, 2.35%. U.S. dollar-denominated, investment-grade floating rate bonds (FLOT) offer 2.40% yields.

Modest returns for sure, but with minimal inflation and interest rate risks, unlike intermediate- and long-term bonds. And with yields only 200 bps below 25-Year corporate bonds.

ETF options: SHY, JPST, corporates with target date closer than 2 years (IBDH, IBDK, BSCI, BSCJ), municipals with target date closer than 2 years (IBMG, IBMH).

Summary

Minimal risk. Low prospective returns (1.85 to 2.40%) while waiting for better opportunities.

Recent trends

In the macro from Investment Works Research, several macro trends are evident since 2015:

• Equity distribution yields have been on steady decline, with stock price increases more than offsetting increases in dividend and share repurchase distributions. The trend has been interrupted this year due to tax reform.

• Intermediate and long-term bond yields have remained fairly stable, with a modest increase in 1H 2018.

• Interest rates have increased every year and are approaching 2%.

• Inflation has increased steadily and is above 2% since last year, in part due to higher energy prices.

• Real GDP growth has moderated somehow since 2015, but remains healthy at some 2%.

Relative to January, the yields of the three main asset classes (stocks, bonds and cash equivalents) have seen modest advances, leaving the relative attractiveness unchanged.

Takeaways and future work

At a TTM PE ratio of 25x, it is no secret that US stocks are expensive by historical standards. Higher valuations mean higher risk and lower prospective returns.

Yet bonds with intermediate and long-term maturities offer underwhelming returns while bearing substantial interest rate and inflation risks.

At 2.4% yields, cash equivalents look like an increasingly attractive instrument to offset equity risk while waiting for better valuations in the equity and bond markets.

Hence, the asset allocation guidelines given earlier this year remain valid:

• Avoid long maturity bonds, allocating the bulk of the funds to stocks and cash equivalents.

• Base the proportion between stocks and cash equivalents on your age, life conditions, risk profile, and personal perceptions on stock market valuations.

• For the stock component, buy a low-fee index ETF or seek higher returns in cheap quality businesses offering asymmetric risk reward opportunities. Our own IW Portfolio (linked earlier in the article) targets 15% compound annual returns, and has performed much better than that since inception (feel free to use it as baseline or inspiration).

• For the cash equivalent component, we have provided links to some of the main ETFs. Feel free to ask for more details.

• If and when bond yields increase their attractiveness relative to expected stock returns, start shifting capital from stocks to bonds (this may start to in 2019 or 2020).

• If and when bond yields increase in absolute terms, start shifting capital from cash equivalents to bonds (this may start to happen in 2019 or 2020).