Investment Theme/LPL Financial SAM Portfolio Update

With the economy about to begin its fifth year of weak expansion, US equity markets making new highs, and investors finally beginning to move money back into stocks, I thought this would be a good time to review what we believe are the major economic and investment themes and how our client portfolios are expected to operate.

We believe a sturdy portfolio normally has four key goals:

1. Provide long term growth

2. Provide current income

3. Protect purchasing power over time

4. Reduce risk of economic and financial shocks

For example, a traditional “balanced” portfolio of 60% stocks and 40% fixed income may do fairly well with #1 and #2, but may be mediocre at #3 and poor at #4. This is why this type of portfolio did well in the 1980s and 1990s, but lost out to inflation during the 1970s and after-inflation has gone nowhere since 2000.

Our client portfolios are designed to address the four key goals. This, however, means that they historically have rarely tracked a single benchmark like the Dow Jones Industrial Average, often underperforming during times of market strength in only one area. Over time, however, patience is expected to reward.

Now, I would like to discuss some broad themes, and how our client portfolios are positioned to attempt to take advantage of them (or changes required to do so.)

Theme 1: Inflation. While we don’t seem to have much inflation at the moment (at least according to official government numbers), many believe that a strengthening economy coupled with the current loose monetary policy will likely lead to some inflation, and perhaps a lot for a while. During periods of inflation, stocks have historically performed weakly while bonds lose value. Historically, the best assets to own have been real assets such as real estate, commodities, natural resources, timber, farmland, and precious metals. Commodities in particular have historically done well during inflationary times.

Investing is Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investments objectives of this program will be attained. The fast price swings in commodities and precious metals investing will result in significant volatility in an investor’s holding and great potential for losses.

Theme 2: US Energy Boom. We believe that the US economy is poised to experience a generational boom in energy. The amount of natural gas and oil discovered in the US and now accessible due to modern technology stands to potentially have us independent from foreign energy sources by 2020. To attempt to take advantage of this opportunity consider investments including Energy Master Limited Partnerships (MLPs) that focus on midstream enterprises, US based natural resource investments, and stocks that may potentially benefit as a consequence of this trend.

Stock investing involves risk including loss of principal. Investing in MLPs involves additional risks as compared to the risks of investing in common stock, including risks related to cash flow, dilution and voting rights. MLPs may trade less frequent than larger companies due to their smaller capitalizations which many result in erratic price movement of difficulty buying or selling. MLPs are subject to significant regulation and may be adversely affected by changes in the regulatory environment including the risk that an MLP could lose its tax status as a partnership. Additional management fees and other expenses are associated with investing in MLPs.

Theme 3: Emerging Markets. While emerging market equities have done poorly as of late in comparison to US equities, we believe the next decade will see significant transformation as many of these countries are poised to potentially grow at significantly faster rates than developed countries and as greater numbers of the poor in these countries move into the middle class. To attempt to take advantage of this theme consider investments such as emerging market equities, emerging market debt, and developed world companies with significant exposure to emerging economies.

Keep in mind that international and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Theme 4: Bond Bubble. Since 1980 interest rates on the 10 year US Treasury Bond have fallen from about 15% to below 2%. This has provided an unprecedented bull market for bonds. At these low rates, there are only two directions we are likely to go: 1) we stay between 1% and 2% on rates due to the US economy experiencing deflation much like Japan has in the past 20 years, or 2) interest rates begin to climb back toward a more normal 4-6%. Since our demographics are significantly different from Japan, I believe the second outcome is more likely. Consequently, bonds will be pressured and may give clients fairly low rates of return (those in longer dated bonds face serious principal risk). To mitigate this risk, investors can consider holding shorter term bonds, ladder their bond securities, own higher yielding bonds, own floating rate notes, own foreign bonds, own multi-sector bonds, or simply own fewer bonds in their portfolio.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Theme 5: The need for more diversified portfolios. The markets tend to run in cycles, and we tend to want more of what is working just when it becomes more dangerous to do so. For example, many investors wanted more growth and technology stocks in 1998-1999 just when that bubble was about to pop. Similarly, investors fell in love with real estate in 2004-2007 as that bubble reached its peak. Today, investors seem to want more bonds and now US stocks as other investments seem to pale in comparison. We believe the best answer is to own very diversified portfolios designed to manage the risk of a blow-up in any one area while hopefully providing meaningful long-term potential returns. We rebalance the portfolio regularly, and then overlay our WealthProtect System strategies to potentially reduce the risk of significant market declines. No strategy, of course, can guarantee success or protect against a loss.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

The Bottom Line

So how are we positioned for these five themes? Actually, we believe fairly well. With our broad exposure to US large, mid and small equities, large foreign equities, emerging market equities, real estate equities, natural resource equities, intermediate bonds, mortgage-backed bonds, multi-sector bonds (also known as strategic income), foreign bonds, a global balanced non-traditional investment, and managed futures (which have historically done well in this type of environment) we also believe we have been well-positioned. Yet, after a review of these themes, we believe we can improve the positioning of our client portfolios we manage in LPL Financial SAM accounts.

1. Commodities. We believe the time has come to add this as a sleeve to the allocations. In addition, we have researched an investment that invests in those commodities that have tight supply and strong momentum. This should better position our client portfolios due to commodities historically being non-correlated with US stocks, and being resistant to inflation. Currently, however, our WealthProtect System strategies has commodities as OUT. So while we will add it as a sleeve, we won’t actually invest until we get a positive IN signal.

2. MLPs. This sleeve will allow us to focus a portion of our client’s stock portfolios to US energy midstream producing companies. MLPS have the advantage of having lower correlation to other stocks, they are a real asset, they take advantage of the energy theme, and they have generous tax-advantaged potential income.

3. Finally, we will reduce the bond exposure in our client’s portfolios slightly. The lost income should potentially be made up by the MLP sleeve of the portfolio. We remained prepared to more significantly adjust our bond exposure as conditions warrant.

So in comparison to a traditional 60% large cap stock, 40% bond portfolio (Growth with Income), our typical allocation would likely look more like this:

Fixed Income: 30%, including intermediate bonds, mortgage-backed bonds, strategic income, foreign bonds, and cash. We also could add Treasury Inflated Protected Securities (TIPS), Treasury bonds, and floating rate notes as conditions warrant. Mortgage backed securities are subject to credit, default, prepayment, extension, market and interest rate risk. Treasury Inflation-Protected Securities, or TIPS, are subject to market risk and significant interest rate risk as their longer duration makes them more sensitive to price declines associated with higher interest rates.

Real Assets: 18%, including real estate, natural resources, and commodities.

Alternative Strategies: 22%, including unconstrained eclectic, global balanced non-traditional, managed futures, and MLPs (which are also a real asset). Alternative investment may not be suitable for all investors and involve special risks such as leveraging the investment, potential adverse market forces, regulatory changes and potentially illiquidity. The strategies employed in the management of alternative investment may accelerate the velocity of potential losses. Managed futures are speculative, use significant leverage, may carry substantial charges, and should only be considered suitable for the risk capital portion of an investor’s portfolio.

I believe this type of asset allocation will help us to better address the four goals of a sturdy portfolio. The exact allocation of your portfolio, of course, will depend on your needs and could be more aggressive or more conservative than this example. The concept, however, is the same.

Thank you for your continued trust and please call your wealth manager if you have any questions.