The Active Asset Allocator model has held a weighting of 60% equities, 20% bonds and 20% gold since June 2012. We have begun to see the first sign of cracks in the stock market's bullish trend, signalling that equities may be approaching a medium-term peak. We are reducing the model portfolio's equity weight by -10% to 50% equities, investing the proceeds into short-dated government bonds and maintaining the 20% allocation to gold. Subject to a continuing deterioration in the technical outlook for stocks, we may move to a fully defensive position (20% equities/60% bonds/20% gold) later this year.
The S&P 500 declined -2% on Wednesday 22nd May following the release of the FOMC minutes at the Federal Reserve. Fed Chairman Bernanke suggested that "certain financial markets were becoming too buoyant" and the Fed may cut back on their QE programme. The rally following that decline has been rather lacklustre to date. We are experiencing a subtle change in the character of the stock market where good news is now being sold. This is happening at a time when investor sentiment is at a bullish extreme (next chart), the S&P 500 is stretched 26% above its 200-week moving average and the cyclically-adjusted P/E (CAPE) on stocks is a lofty 23 times. Also, corporate profit margins in the US have reached 15.1%, almost double the 30-year average of 8.1%. When margins trend back towards their long-term mean (they always do), the valuation argument for buying stocks will become more difficult to make.
In addition to the stock market being overvalued, overbought and stock sentiment being overly bullish, investors are also facing the prospect of rising interest rates across developed world markets. US 10-year treasury yields have increased from 1.6% on 3rd May to 2.1% today, a 31% increase in less than a month. German 10-year yields have rallied 36% from 1.1% to 1.5% over the same time period.
Central bank intervention is no panacea, as the Japanese are now finding out. In our view, the above risks have yet to be fully priced in to equity markets, hence our recommendation to move to a more defensive position.