The purpose of asset allocation is to own minimally correlated assets, which tends to reduce portfolio volatility while delivering the return of the blended classes.

Within the major equity category, asset classes are often thought of as US, non-US developed, and emerging country stocks.

Correlations between those major categories have converged somewhat in the past, but in 2008  they approached unity.

If equity class correlations equal “1″ there is no allocation benefit relating to diversifying the volatility within the equity class.

This correlation table for 1-year returns for various Vanguard mutual funds (with ETF proxies for those mutual funds) shows major and minor equity categories lining up in 2008 with correlations approaching “1″.

Securities listed in image:
VFINX, VTSMX, VFWIX, VDMIX, VEURX, VPACX, VEIEX,
SPY, VTI, VEU, VEA, VGK, VPL, VWO

Asset allocation with regard to equities will work better when correlations begin to diverge.

Richard Shaw
QVM Group LLC

Some of our readers have asked for a list of top yielding stocks by sector.  We built a screen for that and present the five stocks with the highest trailing dividend yield in each sector plotted with the related S&P 500 sector fund.

This does not constitute a recommendation of any kind.  It is a screen that produces food for thought only.  There are probably some stinkers in the list and maybe some good opportunities.

The reason to use the screen would be to find positions that could yield more than buying the index, and that could be balanced among the sectors differently than stocks are balanced within dividend funds (such as DVY, SDY, and VIG).

Before presenting the results, here are the criteria we used to build the screen, showing how the universe reduced as more criteria were applied:

• All stocks covered by S&P Outlook (9,969)
• Market price >$5 (5,281)
• Paid dividends since 1998 or earlier (1,482)
• Market capitalization >= $500 million (853)
• S&P earnings and dividends strength rating B+ or better (493)
• Dividend payout ratio < 100% (390)
• Long-term debt <= 50% of capital (301)
• Trailing yield >0% < 10% (296)

We used the 10% cap on yield along with the S&P financial strength rating to minimize troubled situations.  There are some stocks paying more than 10%, however, that might not be troubled.  Also, some high yielding major names with more than 50% leverage, such as GE, are not included.

The filter is based on the assumption of use by a yield seeking investor who also wishes to limit the amount of leverage employed by the companies in the portfolio.

Note that we did not limit the search to stocks within the S&P 500 index, but did select stocks based on the same industry classifications used in the S&P index.

All filter data is from S&P.  All yield data is from Morningstar.  Charts are from StockCharts.com. The data tools for this or similar screens are readily available to retail investors from those vendors at low monthly costs.

XLB (3.9%), IP (8.00%), AA (5.60%), GEF.B (5.40%), PPG (4.80%), SON (4.80%)

XLE (2.0%), COP (3.40%), MRO (3.30%), CVX (3.30%), ECA (3.20%), PCZ (2.70%)

XLF (8.0%), MI (9.20%), HOG (7.4%), STI (7.20%), TCB (7.10%), BBT (7.00%)

XLI (3.5), MAS (8.20%), HNI (5.20%), OTTR (4.90%), AXB (4.90%), AVY (4.80%)

XLK (2.3%), T (5.50%), MOLXA (4.40%), INTC (3.60%), ADP (3.20%), IBM (2.20%)

XLP (2.9%), MO (8.40%), UVV (5.90%), CAG (4.50%), KMB (4.30%), SYY (4.00%)

XLU (4.2%), AEE (7.40%), PNW (6.30%), ED (5.90%), ATG (5.30%), ALE (5.30%)

XLV (2.7%), PFE (7.00%), LLY (4.80%), JNJ (3.00%), ABT (2.60%), MDT (2.20%)

XLY (2.5%), HOG (7.1%), MDP (4.8%), VFC (4.10%), GPC (3.90%), WHR (3.90%)

Take this for what it is — a quantitative screen, and nothing more.

There is no analysis beyond strictly applying the filter criteria, which may or may not produce good results, or be suitable for you.

Not all found companies are necessarily attractive, and not all attractive high yielding companies have been found.

This filter is just a way to reduce the field of examination in the search for investment ideas.  More quantitative and qualitative review is necessary to determine if any of the identified companies could be attractive investments for any particular portfolio.

Other filters generating other lists should also be evaluated.

Richard Shaw
QVM Group LLC

As the bond markets improve, and equities makes attempts to rise, convertible securities hold an interesting and potentially attractive position within the capital structure of speculative companies.

Among the convertible securities funds, we like Vanguard Convertible fund the best (symbol VCVSX).  Unlike most other types of bonds, there are no ETF products for convertible bonds, although there are some preferred securities CEF products. We have no current opinion about the CEFs, except to say that generally we prefer mutual funds or ETFs over CEFs.

VCVSX versus convertible CEFs:

Those convertible CEFs with over $100 million of assets and 5 years or more of history are: JQC, NCV, AVK, CHY, and CHI. Here is how their recent performance compares to VCVSX (shown in solid black line).

Convertible Funds versus Other Bond Fund Types and the S&P 500:

We prefer VCVSX for convertible bond (and some preferred) exposure.  Here is how that fund compares to other types of bond funds and the S&P 500 in terms of yield, credit quality and duration.

click image to enlarge

Type, Yield, Credit Quality, Duration, ETF Alternative

Credit Rating Agency Scales

VCVSX is rated Ba2 (speculative grade, below investment grade, “junk”)

Chart Comparisons - Types of Bond Funds:

Bond ETFs have a relatively short history.  The chart that follows compares the Vanguard Convertible fund (VCVSX) to an intermediate Treasuries fund (IEF), an investment grade corporate bond fund (LQD), a high yield bond fund (HYG), and a national municipal bond fund (MUB).

The convertible bond fund has experienced the deepest drop in value over the past 18 months, and has recovered less than the high yield (junk) fund.  That is either a warning sign or a remaining opportunity to buy depressed bonds before spreads improve.

Chart Comparisons - S&P 500 versus Aggregate US Bonds versus Convertibles:

We use VBMFX for Barclay’s Aggregate US Bonds (alternatives: AGG, BND), and VFINX for the S&P 500 (alternatives: SPY, IVV) in these charts.

19 Years

10 Years

5 Years

1 Year

3 Months

Management:

VCVSX is managed for Vanguard by OakTree Capital Management and a dedicated, convertibles-only team overseeing about $7 billion of convertibles.  VCVSX has about $700 million of assets. Larry Keele is the portfolio manager.

Portfolio Composition:

The average coupon is 2.5%, but the SEC yield is 4.95% (below par market valuation - no net conversion premium).  Portfolio turnover is 78% per year.  Holdings are 7.3% convertible stocks, 84.1% convertible bonds, and 8.6% cash reserves.

Credit quality spans Moody’s “Aa” (investment grade) to less than “B” (worse than “junk”) with nearly 36% “not rated”, with a net “Ba2″ average quality (middle “junk”).

click to enlarge

The top ten positions account for 27% of assets.

Returns and Expenses:

The fund is actively managed, and therefore does not have the bare bones expense ratio of an index fund, but the ratio is still moderate at 77 basis points.

Returns through 11/30/2008 have been:

• 1-year: -34.81%
• 3-years: -5.37%
• 5-years: -0.67%
• 10-years: +4.42%
• since inception (6/17/1986): 6.79%

Why Not Just Buy High Yield Equities?

We may be at or near an historic opportunity to purchase equity assets at bargain prices. If you are certain of that, then high yield equities may make better sense.  We are still tentative on equity recovery and will likely remain so until after January.

The  “get paid while you wait” argument can be made with beaten down equities, but the risk of value falling (even permanent loss) is greater with equities than with bonds.  The higher in the capital structure you are, the lower the risk of permanent loss you have for any given issuer.

US Treasuries are at the top of the global capital structure, and are being flooded with Dollars.  The result is historically low yield and possibly significant risk of capital losses as eventual market recovery causes assets to be reallocated out of Treasuries into higher risk / higher potential return assets (both bonds and stocks).

Also, until the “E” in “P/E” becomes more believable and stops being revised down, and until the “G” in “PEG” becomes more believable and stops being revised down for both companies and countries, it is hard to say which equities are really cheap and which are really expensive.

Therefore, we prefer to be higher in the capital structure until more of the smoke clears.  Convertibles are a bit higher than equities, although generally below traditional bonds, and certainly lower in the national capital structure than Treasuries and municipals.

We have been stepping into municipals, investment grade corporate bonds, preferred stocks, inflation protected Treasuries (see TIPS article), and a little bit of high yield (below investment grade) bonds.

Conclusion:

We think the history of the convertible class, and VCVSX in specific, and the transitional condition of the bond and stock markets, support including convertible exposure in small amounts for those accounts which are suitable for inclusion of speculative (”junk”) assets.

Being paid more than twice the treasury rate, and about the same as the overall bond market rate, to wait for a possible capital gain from a future conversion premium seems to us to be a more conservative form of speculation than taking a direct equity position.

Since the yield on convertibles such as VCVSX is more than 1/2 of the long-term total return on stocks, we are comfortable with the long view for 1% to 5% of assets within an overall allocation, depending on the investor profile.

The author currently holds 2% of personal assets in VCVSX.

[Securities mentioned: SPY, IEF, AGG, LQD, HYG, MUB, VFINX, VFITX, VWITX, VBMFX, VWESX, VCVSX, VWEHX, JQC, NCV, AVK, CHY, CHI]

Richard Shaw
QVM Group LLC

We are waiting watchfully for a good re-entry point for US equities using the substantial cash position we raised last summer.

The critical factors we are watching to identify a prudent re-entry point — information we will use to become comfortable that the storm we avoided has passed by — are:

1. Technical Market Factors
2. Valuation Fundamentals
3. Risk Levels
4. Government Intervention Policies
5. Economic Conditions

Economic conditions are poor and the time frame to recovery still seems longer than the 6-12 months that the markets are generally assumed to discount in advance. Q4 earnings reports may be telling.

Government intervention policies are not yet fully established or implemented.  Unkowns abound with respect to Congressional action on several fronts, ranging from possible 4.5% new mortgages to auto company bailouts.  A new president and cabinet plan some sort of massive stimulus package that has yet to be defined and debated.  We need to wait until January or February to begin to get good clarity on that.  Foreign government and supra-national agency (e.g. IMF) policies are continuing to be announced.  Eventually, if enough money is applied to the problems, reflation of economies will happen, but what will happen between then and now, and how long it will take to get to the other side, is not yet clear.

Risk levels are still extraordinary.  Michael Santoli wrote in this week’s Barron’s about research published by Vince Farrell as follows:  “Since 1950, over a span of nearly 15,000 trading days, the Standard & Poor’s 500 has gained or lost 4% or more in a day only 68 times (33 down, 35 up).  Of those 68 days, 28 have occurred in the past three months.” We think that is a clear indication of the abnormally high current risk level.

Valuation fundamentals are opaque, but probably unfavorable.  While P/E ratios are average or slightly below, the “E” is still coming down.  Dividends are still being cut.  Congress is still talking about prohibiting dividends by companies receiving bailout money. Business failures are still rising.  The possible economic collapse due to bank failures has been replaced by possible economic collapse due to auto company failures.  Basic materials costs have already collapsed due to lack of manufacturing demand. Key economies in China and India are still growing, but the rate of growth is falling.

Technical factors for the asset categories we are watching are mixed.  We are monitoring ten bellwether asset categories as macro level representations of the larger world of investment assets (asset type / proxy fund):

• US Stocks (VTI)
• Non-US Developed Market Stocks (EFA)
• Emerging Market Stocks (EEM)
• US Real Assets (VNQ)
• Global Commodities (DJP)
• US Aggregate Bonds (AGG)
• US Treasuries 7-10 Years (IEF)
• US Dollar Index (UUP)
• Crude Oil (USO)
• Gold Bullion (GLD)

Simple, short-term candlestick charts for each of the asset category proxy funds shows some categories doing well, some doing badly and some trying to do better.

click images to enlarge

AGG, IEF and UUP are strong.  USO and DJP are doing badly.  VTI, EFA, EEM, VNQ, and GLD are trying to do better.

From a rotation perspective, we do have some concerns about Treasuries (IEF) and the Dollar (UUP).  When risk appetites return, rotation out of Treasuries to riskier bonds or stocks will likely depress Treasury prices.  Also when the trillions of new Treasury issuance take place to fund the bailout, Treasury prices may fall to compensate buyers for the risks they are asked to assume.  Similarly, the Dollar may have strengthened in great part due to the rush to the liquidity and relative safety of Treasuries.  The Dollar is strong, but there are questions about how long that can last as questions about the US economy persist and with historically low short-term interest rates.

For now, bond allocations are doing mostly OK.

Closer Look at US Stocks:

Let’s take a closer look at US stocks as represented by the S&P 500 index.  We are looking at VTI (total US stocks) generally, but the S&P 500 has a longer history, which makes it better for long-term historical views.

The top level technical issue is establishing the major trend as up, down or sideways.  The time frame used to determine trends depends on investment time horizon.  Just to cover all the bases for different prospective investors, let’s look at a wide time range — 27 years, 3 years, 1 year, and 3 months.

The charts that follow have some annotations identifying some potentially interesting attributes of the charts patterns.

The 10-year Treasury bond interest rate is plotted on the same space as the S&P index levels (right scale for S&P index, and left scale for Treasury yield).  The charts also present simple moving averages as overlays of the index levels, and present price and volume oscillators that variously indicate money flow, momentum, direction and extreme conditions (overbought and oversold).

The charts use these indicators in the panels below the price chart panel (descriptions adapted from  John Murphy’s www.StockCharts.com)

• Average Directional Index (ADX): ADX (a bounded oscillator) indicates the strength of a current trend whether up or down.  It is an oscillator that fluctuates between 0 and 100. Readings above 60 are relatively rare. Low readings, below 20, indicate a weak trend and high readings, above 40, indicate a strong trend. The indicator does not grade the trend as bullish or bearish, but merely assesses the strength of the current trend regardless of direction.
• Relative Strength Index (RSI): RSI  (a bounded oscillator) compares the magnitude of gains to the magnitude of losses, and expresses the calculation as a number within a band from 0 to 100. It does not measure strength relative to another security, but rather measures the strength of directional moves by a single security.  It is useful for identifying extreme conditions (movements too far, too fast in either up or down direction) called “overbought” (typically over 70) and “oversold” (typically under 30).
• Moving Average Convergence/Divergence (MACD): MACD (an unbounded, centered oscillator) uses three moving averages to indicate direction and momentum.  It subtracts a longer moving average from a shorter moving average creating a line that oscillates around a center at zero with no upper or lower limits.  The third and shortest moving average moves around the oscillator to serve as a signal line when it crosses the oscillating line.
• Chaikin Money Flow (CMF): CMF (an unbounded oscillator) evaluates the cumulative flow of money into and out of a security.  It establishes a point value for the closing price position within the period’s price range, then multiples that by the volume for the period and then maintains a running total for the selected number of periods.
• The Money Flow Index (MFI): MFI (a bounded oscillator) is a momentum indicator that is similar to RSI in both interpretation and calculation (with a range from 0 to 100), except that it is volume-weighted.   It compares “positive money flow” to “negative money flow” to reflect the momentum of money flowing in and out of a security.

S&P 500 Monthly from 1981

(A) the October 1987 crash is the only period in the last 27 years that visually resembles the price change since September.

(B) the point in 1994 where HTML was introduced to enable internet images — when the internet took off and so did the dot.com bubble.

(C) the 2002-2003, post dot.com, post 9/11 bottom which appears to be a potential bottom level for the current market (a possible “support” level)

(D) the yield on 10-year Treasury bonds

(E) RSI showing a potentially oversold current condition

(F) MACD showing negative momentum and no sign of a reversal

(G) ADX showing a moderately strong trend, which the price chart visually shows as downward.

S&P 500 Montly for 3 Years

Red and green arrows highligting some points at which down (red) indications were present, and at which up (green) indicators were present.

S&P 500 Weekly for 1 Year

Horizontal lines emphasize the current values of the 13-week, 26-week and 52-week simple moving averages (”SMA”) which may be “attractors” for the price in a reversion to mean scenario.

S&P 500 Daily for 3 Months

The 10-day SMA is about to make a bullish cross of the the 20-day SMA, but it made such a cross in early November, only for the price to fall shortly thereafter.  There were big government intervention surprises back then, but there may be at this time too — GM, Ford and Chrysler. The 20-day, 50-day and 200-day SMA’s are downward tilted, which is still bearish.    ADX says trend is moderate but weakening — possibly a pre-positive sign.  RSI is so-so.  MACD made a bullish cross-over in late November, but it did that in early November too.  CMF Money flow has turned as positive as it was in September, before the big market crack.  MFI money flow momentum has been increasing in November, but is not in an extreme condition.

Third Party View:

Market Edge Second Opinion is a technical service that uses multiple technical criteria.  They rate our ten bellwether asset categories as follows (”+” means improving and “-” means worsening — our short hand for Market Edge’s more complete explanation):

• AVOID (+): US Stocks (VTI)
• NEUTRAL (+): Non-US Developed Market Stocks (EFA)
• NEUTRAL (+): Emerging Market Stocks (EEM)
• AVOID (-): US Real Assets (VNQ)
• AVOID (-): Global Commodities (DJP)
• NOT RATED: US Aggregate Bonds (AGG)
• NOT RATED: US Treasuries 7-10 Years (IEF)
• LONG (-): US Dollar Index (UUP)
• AVOID (-): Crude Oil (USO)
• LONG (-): Gold Bullion (GLD)

Summary:

No matter the assessment, each investor has their own risk tolerance, future financial sources, liabilities and investment time horizon.  It is impossible to say what everyone should do, because we are all different.  You need to make your own assessment of your situation, the market conditions and probable futures.

Generally, it looks to us as if the markets are trying to behave in a hopeful manner, perhaps in recognition that governments are determined to fix things up, but with a backdrop of terrible economic conditions, uncertain timing of uncertain outcomes, at a time when risk of absolute loss due to default and bankruptcy and risk of violent value fluctuations are front and center.

You, or you and your advisor, must decide where in the risk spectrum you should insert your money. Are you a 25-year old “early saver”?  Are you a gambler by nature?  Are you a “prudent man”?  Are you done saving to increase your portfolio and now nurturing it for the long term?  If you lost 20% would your life style be compromised?  If you lost 50% could you maintain your lifestyle?  Do you have specific liabilities for which you should protect matching assets? Are you a non-profit or other organization with investment guidelines or restrictions?  Can you sleep at night with the risks you have or are thinking about taking? These are some of the kinds of questions you need to answer before you decide what to do and when.

Richard Shaw
QVM Group LLC

These charts show the relative price performance of twenty selected asset categories versus the S&P 500 index on a monthly basis over the past three years. They may help create or maintain perspective as markets fluctuate so violently today.

Future markets may be shifted into new relationships for some time due to the current malaise and government responses to the problems, but it is not possible think usefully about a shifting relationship, unless you first have a clear idea of the base from which the shift may take place.  These charts may help somewhat with clarifying the base.

Charts are courtesy of www.StockCharts.com.

In each cash, the black line is for the S&P 500, represented by the exchange traded fund SPY.  The red line is the relative performance line versus the S&P 500 for the subject asset category, represented in some cases by an index and in other cases by a proxy fund.

The right scale is the SPY price.  The left scale is not particularly interesting for our purposes here.  It is the price of the subject index or fund divided by the price of SPY.  It should be ignored in the context of this article.

The important fact is that a rising red line indicates the subject index or fund outperforming the S&P 500, while a declining red line indicates the subject index for fund underperforming the S&P 500.

10-Year Treasury Bond
(nearestproxies IEF or TLH)

Lehman Aggregate US Bonds
(proxies AGG, BND and VBMFX)

Long-Term Investment Grade US Corporate Bonds
(proxy LQD and VWETX)

Below Investment  Grade (Junk) US Corporate Bonds
(proxy HYG and VWEAX)

Intermediate-Term Tax Exempt Municipal Bonds
(proxy VWIUX)

Non-US Developed Stock Markets
(proxy EFA and VEA)

Japan
(proxy EWJ)

Germany
(proxy EWG)

Canada
(proxy EWC)

Singapore
(proxy EWS)

Emerging Stocks Markets
(proxy EEM and VWO)

China
(proxy FXI)

India
(proxy INP)

Brazil
(proxy EWZ)

Russia
(proxy RSX)

Turkey
(proxy TUR)

US Equity REITs
(proxies VNQ, RWR, IYR)

DJ-AIG Commodity Index
(proxy DJP)

Gold Bullion
(proxy GLD)

West Texas Intermediate Crude Oil
(poor proxy USO — contango and backwardization)

US Dollar Index
(proxy UUP)

Richard Shaw
QVM Group LLC