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Taking a tactical look at 2014

When markets are in a choppy phase, tactical asset allocation comes into its own
December 20, 2013

Tactical asset allocation - or market timing - has proved a fruitful approach over the last 13 years as a whole. Whereas simply buying and holding does better during eras when equities trend relentlessly upwards for years on end - as in the 1980s and 1990s - switching in and out works better in troubled phases. I do not believe that the troubled phase that began in 2000 is over, even though the lows have already occurred. Tactical investing could therefore be the way to go in 2014.

I have been mainly bullish on equities since late 2010. My optimism of late has been based largely on quantitative easing (QE), however. Given still feeble economic recovery across much of the developed world, I do not think that stocks would have reached the levels that they have done without monetary largesse. My view is that the economic and stock market expansion is getting long in tooth and the withdrawal of QE poses a major risk. But I am willing to stick with the bull run for the moment.

 

UK equities

Large-cap stocks have been the worst bet in the UK for four out of the last five years, with the FTSE 100 lagging behind the FTSE 250 and FTSE Small Companies indices. This is in keeping with the long-term pattern, too. Whereas a £100 stake in UK large caps in 1955 with dividends reinvested would have become only £20,754 if held until the present, the same holding in smaller-cap UK stocks would have become £477,767.

 

 

Long streaks of underperformance by UK large-caps like this one have in the past given way to strong comebacks. However, this generally happens when a recession or bear market strikes or when the valuation gap between large caps and small caps becomes excessive. For now, there is no sign of either. Economic growth in the UK is picking up, while small-cap valuations are not out of line with the long-term trend.

 

 

The biggest risk to smaller-cap stocks in 2014 comes from the possibility of a nasty correction or bear market in stocks. The most likely trigger for such a shakeout would be the withdrawal of QE in the US or another shock in the eurozone. As a result, my tactical preference remains for staying long of the FTSE 250 in preference to the FTSE 100, but being ready to exit if my momentum model goes bearish.

If the recovery in the UK and elsewhere keeps going, the normal expectation would be for British value stocks to beat growth stocks. However, the relationship has broken down a bit in recent times. Still, this leaves scope for some catch up to take place. If so, buying a high-yield UK exchange traded fund (ETF) would be one possible way to exploit this.

 

US equities

Using long-term valuation tools, US equities are dear right now. The cyclically-adjusted price-earnings ratio of more than 25 is suggestive of very disappointing real returns over the next decade. This does not mean that Wall Street is in a bubble right now, but the current richness of stocks is getting more and more out of line with the less than robust outlook for the US economy. Nor does it tell us much about next year: a dear market can get dearer still in the short run.

My bullishness towards US stocks in recent years has largely been a result of the Fed's QE programme. I am therefore fearful of what will happen as this stimulus begins to be withdrawn. The suspension of QE in 2010 and 2011 saw stocks plunge. While the withdrawal is set to be staggered this time around, the risks of a big decline is significant. Tactically, I am going to remain long for now, but be ready to make a swift exit once my tactical model turns tail.

 

Japan

The immediate outlook for Japanese stocks is still brighter than it has been for a long time. The Japanese authorities are taking a more robust and comprehensive approach to ending the country's multi-year economic funk than they have before. Torrents of newly-printed money have forced down the yen and have reversed the falls in consumer prices that have been ongoing for so long. Cutting Japan's hulking debt burden and reforming the economy will take longer, but the omens are good for now.

 

 

Nikkei's vibrant new uptrend

Despite years of poor performance, Japan's stock market is not screamingly cheap based on 10-year average earnings. It actually lies among the dearest developed markets on that basis. However, this need not hold up further gains in the near term. To ride the uptrend, a sterling-hedged Japanese ETF is the best idea. The continued gains I expect will almost certainly be accompanied by more weakness in the currency.

 

European equities

The best value in developed world stocks likely lies in continental Europe. Based on the cyclically-adjusted price-earnings ratio, the cheapest markets are Austria, Ireland, Italy, the Netherlands, Portugal and Spain. While I do not believe the Eurozone's underlying problems to have been resolved yet, I am bullish on the outlook for further stock market recovery. My main reservation is that many others have the same view, whereas the best returns often happen in widely hated markets.

 

 

The eurozone is unlikely to suffer sustained deflation as Japan has, despite the current scare. Ultimately, the European Central Bank is likely to unleash aggressive monetary policies, as have its counterparts in the UK, Switzerland and the US. These should prove helpful to equities, as well as buying further time for the bloc's most troubled members to put their houses in order. As such, I am keeping faith with continental stocks going into 2014, especially the cheaper ones.

 

 

Emerging markets

Equities in developed countries have had the upper hand over their counterparts in emerging markets (EMs) since autumn 2011. In the first 11 months of 2013, the MSCI World index – which covers stocks from 23 developed countries - is up almost 22 per cent, while the MSCI Emerging Markets index is down 5 per cent. What could revive EM stocks in 2014?

 

EMs: cheap but going sideways

It has often paid to buy EMs during periods of strength in the global economy, when the US dollar has weakened and when they've been very cheap compared with developed market shares. On a trailing price-earnings ratio, EM shares are somewhat cheap, both in their own right and in relative terms. However, the withdrawal of QE in the US threatens to boost the dollar and undermine the MSCI World index. This could lead to a buying opportunity going forward, but developed markets are preferable for now.

 

Gold

The yellow metal is in a sorry state right now. At its lowest ebb in 2013, its spot price was 37 per cent below its record all-time peak of September 2011. There is a clear danger that this weakness persists into 2014. A strengthening US dollar and growing confidence among investors that the crisis has been tamed could further reduce demand for gold as a safe-haven investment.

 

 

Gold's mid-70s slump and recovery

Taking a longer-term view, I remain bullish on gold. The authorities in the US, Japan, and Europe have already committed themselves to a strategy of inflating away their giant debt overhang. Ultimately, this will reignite the boom in gold that began in 1999. Tactically, I remain negative for now, though, respecting the clear downtrend that is in force. We should remember that gold halved midway through its 1970s bull run before it then soared 700 per cent. We may well be due something similar this time.