Individual Asset Allocation Exercise

This exercise involves an analysis of general economic conditions or systematic risk, i.e., the risk that affects all industries and companies, in the U.S. economy. You are asked to determine in percentage terms an optimal allocation of $1,000,000 among the following three asset classes: U.S. equities, U.S. Treasury bonds, and cash. The goal is to maximize your expected return over the next 12 months. You are asked to write a 1-2 page paper providing your analysis of the asset classes’ return prospects and your justification of your allocation of monies among them.

First, consider historical returns on various asset classes in the U.S. Look at Figure 10.4 on p. 298 of your textbook. Also, in Table 10.2 on p. 305 you can see that historically equities outperform bonds in terms of average return but they also carry more risk as defined by their standard deviations. These historical results show that on average the return on equities is highest but in some specific years this may not be true. For example, look at Table 10.1 on pp. 302-303 and you can see that in three out of the five years from 2000 to 2004 the annual return on large-company stocks (defined in the text as the S&P 500)[1] was negative.

In this exercise your investment horizon is one year. In considering your allocation among U.S. equities, long-term Treasury bonds, and cash to maximize your prospective return over the next twelve months, we might next more precisely define these asset classes. We can define U.S. equities as the Standard and Poor’s (S&P) composite index [“At present…includes 500 of the largest (in terms of market value) stocks in the United States.” (p. 304)]. More detailed information is available directly from Standard & Poor’s:

http://us.spindices.com/indices/equity/sp-500

Excel spreadsheets of Index returns dating from 2009 back to the late 1980’s are available to download at

http://research.stlouisfed.org/fred2/series/SP500/downloaddata

Web-based finance sites also customarily carry data on the S&P 500. For example,

–at CNNMoney.com: http://money.cnn.com/data/markets/sandp/?

–at Bloomberg: https://www.bloomberg.com/quote/SPX:IND

–at Yahoo! Finance: http://finance.yahoo.com/echarts?s=%5Egspc+interactive

We can define long-term Treasury bonds as 30-year U.S. government bonds. Historical data on yields on debt claims are available from the Federal Reserve via  http://www.federalreserve.gov/releases/h15/data.htm. For historical daily rates on the 30-year T-bond, defined as “Market yield on U.S. Treasury securities at 30-year constant maturity, quoted on investment basis” go to

https://www.federalreserve.gov/datadownload/Preview.aspx?pi=400&rel=H15&preview=H15/H15/RIFLGFCY30_N.B

Long-bond Treasury rates are also available from the following sites:

— http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml

— http://www.bloomberg.com/markets/rates/index.html

The third alternative is cash. Assume no return on that share of your monies held in cash.

This analysis necessarily involves your assessment of systematic risk, i.e., the risk that affects all industries and companies, in the U.S. economy over the next twelve months. Let’s more fully define systematic risk. According to the textbook, systematic risk “…influences a large number of assets, each to a greater or lesser extent…[and is] sometimes called market risk…Uncertainties about general economic conditions, such as GDP, interest rates, or inflation, are examples of systematic risks. These conditions affect nearly all companies to some degree” (p. 340-341). Your task is to consider your investment alternatives in light of systematic risk expected over the coming year.

Your considerations about investing in U.S. equities will thus involve your determination of the near-term prospects for the U.S. economy and the implications of these prospects for U.S. equities.

A useful site for recent and upcoming U.S. macroeconomic data releases is https://www.bloomberg.com/markets/economic-calendar . Click on the highlighted report or “Consensus” next to any particular report to get data (either recently reported or the near-term consensus, respectively), the schedule of future data releases, and a definition. More generally, many other sites provide information on macroeconomic data, such as:

— http://info.wsj.com/classroom/Indicators/guide.html

— http://www.bea.gov/

— https://www.gpo.gov/fdsys/browse/collection.action?collectionCode=ECONI

— https://fred.stlouisfed.org/

Finally, the decision to invest in 30-year U.S. T-bonds importantly involves expectations about future inflation and the term structure of interest rates,  i.e., “the relationship between short- and long-term interest rates” (p. 158). On p. 155-156 of the textbook the distinction is made between “real” interest rates and “nominal” interest rates.  “Nominal” interest rates are the rates that are quoted in the financial press; they are the rates at which we borrow and lend. Per the approximated Fisher equation (Eq. 5.4 on p. 156), the nominal rate includes the so-called inflation premium, h, so that the higher the expected inflation, h, the higher the nominal rate, all else equal. In considering longer-term T-bonds one must also be aware that, in addition to expected long-term inflation, there is greater interest rate risk: “…longer term bonds have much greater risk of loss resulting from changes in interest rates than do shorter-term bonds” (p. 158). Specifically, should interest rates increase, the market value of 30-year bonds will fall and the fall will be more dramatic for a 30-year T-bond than for a 10-year Treasury note. Conversely, price gains from any drop in rates will be more dramatic the longer the term to maturity on a bond. One should also keep in mind that while in general longer-term rates are typically higher than short-term rates for the same level of overall risk, there have been occasions when the reverse is true, and the term structure of interest rates is inverted. (Please see Figure 5.5 on p. 157 on the historical relationship between long-term and short-term U.S. interest rates.) Finally, in finance we assume that there is no credit or default risk on Treasury securities. It is assumed that there is no risk that the U.S. government will fail to meet its outstanding debt obligations. This is, of course, not the case for corporate issuers.

Finally, what are the implications of interest rate changes for the equity market? Here is one response to this question: http://www.investopedia.com/articles/06/interestaffectsmarket.asp

Here is another: https://www.tiaa.org/public/pdf/C37368_impact_of_rising_int_rates_on_equity_markets.pdf

Questions for Individual Asset Allocation Exercise:

1.      Allocate your fictional $1,000,000 among the following three asset categories:

2.      Justify your allocation based on your outlook for systematic risk in the U.S. economy over the next year.

Amount available for investment is $1,000,000, and it can be allocated to the equity, US 30-year Treasury bonds, and cash. There are various factors that influence the allocation of funds.

GDP forecast for 2015 is expected to be about 3%. Various sources predicted the GDP of US is expected to increase due to the economic stability except for United Nations forecast all forecasted that GDP of US will be greater than 3% from the current level of 2% to 2.5% (Lapitskiy, 2014). Inflation rate of US is expected to increase slightly from the current level which cannot expect to have any adverse impact over the economic growth (Knoema.com, 2014).

But the great advantage for the country is the continuously reducing unemployment rate. About 5.7% to 6.05% is the expected unemployment rate which decreased from about 7.4% during 2013 (Knoema.com, 2014). This clearly indicates that the overall growth in the economy will be beneficial. Any investment made at this point of time will be beneficial for the investor. It indicates that the overall productivity and industrial growth will be high. It will have a direct impact over the stock price of the company. If overall stock price increases, then entire stock market will improve and get stabilized.

Overall there is expected increase in the current account deficit balance of US (Knoema.com, 2014). It indicates that economy will spend more and will require more time to get stabilize. But only with this balance one cannot predict the performance of the economy. US economy is growing, and the amount of availability of skilled labors is increasing in the market. There are some structural difficulties faced by the country, but it is not expected to have an adverse impact over the entire economy (Conerly, 2014). US stocks are expected to beat the global equity market the overall increase the stock index was 11% when compared to 7.4% of Japan and 3.2% of Europe (Wang, 2014).

Let us take for example growth in health care industry is tremendous and is creating 25,000 jobs per month, and it indicates a significant growth (Diamond, 2014). Investing in this industry will provide a higher return. This enables in making a decision of investing 70% in stocks. US 10-year Treasury yield is expected to reach about 3%  which is at current level of 2.35% it is implied that there will be either increase or will remain constant for the 30-year Treasury yield (Wang, 2014). It is the reason for allocating about 20% of the portfolio in the Treasury bonds.

US dollar is expected to remain stronger in the future; it is clear from the level of expected growth in GDP and decrease in the unemployment rate. When the economy grows, it indicates that the exchange rate of the country will remain stronger (Wang, 2014). Mostly it is expected to strengthen against yen and euro. Thus, only 10% of the portfolio is held as cash.

Expected growth rate and historical growth rate indicates about the future performance of the stock market. Stock market return is expected to be good in the coming year which enable in allocating 70% of the funds in the equity investment. In the case of 30-year Treasury bond, there will be either no change or increase in the yield is expected which enable in allocating 20% of the funds. Finally, 10% is expected to maintain as cash as US dollar is expected to strengthen.

Appendix:

Source: Yahoo Finance, 2014

Reference

Conerly, B. (2014, January 22). Economic Forecast 2014-2015: Looking Better With Help From Oil And Gas – Forbes. Retrieved from http://www.forbes.com/sites/billconerly/2014/01/22/economic-forecast-2014-2015-looking-better-with-help-from-oil-and-gas/

Diamond, D. (2014, June 6). Since Obamacare Passed 50 Months Ago, Healthcare Has Gained Almost 1 Million Jobs – Forbes. Retrieved from http://www.forbes.com/sites/dandiamond/2014/06/06/since-obamacare-passed-50-months-ago-healthcare-has-gained-almost-1-million-jobs/

Knoema.com. (2014). US Inflation Forecast 2013-2015 and up to 2060, Data and Charts – knoema.com. Retrieved from

http://knoema.com/kyaewad/us-inflation-forecast-2013-2015-and-up-to-2060-data-and-charts

Lapitskiy, I. (2014). US GDP Growth Forecast 2014-2015 and up to 2060, Data and Charts – knoema.com. Retrieved from

http://knoema.com/qhswwkc/us-gdp-growth-forecast-2014-2015-and-up-to-2060-data-and-charts

Wang, L. (2014, November 20). Goldman Sachs Sees ‘Low Return World’ in 2015 With Stocks Rising – Bloomberg. Retrieved from

http://www.bloomberg.com/news/2014-11-19/goldman-sachs-sees-low-return-world-in-2015-with-stocks-rising.html

Yahoo Finance. (2014). ^GSPC Historical Prices | S&P 500 Stock – Yahoo! Finance. Retrieved from http://finance.yahoo.com/q/hp?s=%5EGSPC&a=11&b=5&c=1980&d=11&e=5&f=2014&g=m

[1] For a brief history of the S&P 500 see https://www.investopedia.com/ask/answers/041015/what-history-sp-500.asp