Investment Outlook Q3 2019 - Barrett Asset Management

Investment Outlook Q3 2019

Changing Approaches to Asset Allocation over Time

Most investment managers view asset allocation--or the mix of bonds, stocks and other assets in a portfolio--as the most important decision an investor can make. In this Outlook, we refresh our thoughts on the process of determining the relative appeal of stocks and bonds.

Investor approaches to asset allocation have changed radically over the past several decades. Fifty years ago, portfolio managers constructed portfolios with a mix of 60 percent in stocks and 40 percent in bonds. The stock allocation was expected to produce a higher return than the bonds, while the bonds generated greater income and reduced the volatility from the stocks. Publicly traded U.S. stocks and bonds were the meat and potatoes of most portfolios during this time. In practice, investment managers hugged the 60/40 target rarely allowing a portfolio to drift far from the predetermined mix.

Standard & Poor's 500 Index Dow Jones Industrial Average NASDAQ Composite Index Dow Jones Global (ex U.S.) Barclays Aggregate Bond Index

CLOSE 9/30/19

2,977 26,917

7,999 242

2,221

TOTAL RETURNS

Third Quarter 2019

2019 Year-to-Date

+1.70%

+20.55%

+1.83%

+17.51%

+0.18%

+21.54%

-2.31%

+8.90%

+2.27%

+8.52%

BARRETT

ASSET MANAGEMENT

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As financial markets and emerging economies developed around the world, large U.S. investors took a more global approach to investing and incorporated more international securities into portfolios. Leading edge investors managing massive pools of money went even further. The Yale endowment, for example, pioneered the move into even more adventurous assets by adding in commodities, hedge funds, venture capital, and private investments to the mix. The plain old vanilla 60/40 asset allocation approach was soon deemed out of fashion. The adoption of the more "new age" endowment approach ultimately spread from endowment portfolios to portfolios managed by private banks.

levels would lead to sizable losses. And, the highly diversified "modern" approach seems to be effective at reducing risk but at the cost of lower returns and lower liquidity. Its widespread adoption by the biggest money managers has also resulted in huge piles of "copycat" money piling into the same "opportunities."

The different approaches have produced vastly different portfolios and results. The performance returns for the new, more diversified approach, for example, have trailed in comparison to the simpler 60/40 domestic mix over the past decade. One reason for the better performance of the 60/40 approach is that both domestic bonds and stocks have been in stunningly powerful bull markets-- stocks for ten years and bonds for nearly forty years. When endowments decided it would be better to be more diversified, they undoubtedly underestimated the outlook for plain old U.S. stocks and bonds. Their ultra-diversified portfolios, however, have in most cases met the objectives of the endowments with reduced volatility. Their approach remains the asset allocation gold standard for diversifying and hedging financial assets of large pools of money.

We are not completely sold on either approach. Developing an all-weather asset allocation strategy is easier said than done. It requires identifying what opportunities are currently available in financial assets, and investment opportunities can evaporate over time. For example, the rigid 60/40 approach is founded on the idea that bonds will generate a reasonable amount of income with limited volatility. That is not the case today. Yields are too low and any increase in yields from these

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Asset Allocation in a Period of Low Interest Rates

Low and negative bond yields around the globe have created an asset allocation dilemma for investment managers today that no one we know of ever anticipated. In today's low interest rate environment, some asset allocators have adopted the "TINA" approach, or There Is No Alternative to stocks allocation. This healthy allocation to stocks has worked recently, but what are the odds that it will work going forward?

When investment groups try to decide how much to allocate to any asset class, the starting point begins by looking at the yield on the 10-year U.S. Treasury Bond. Why the 10-year bond? These bonds are the safest investment in the world--not necessarily the best investment, but the safest. Investors can confidently assume these bonds are more secure from default risk than putting

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money anywhere else, such as in foreign bonds, domestic municipal bonds, corporate bonds, bank CDs, and so on. Therefore, to allocate money to other assets, the allocator must believe that they will earn higher returns than the 10-year bond without undue risk. The yield on the 10-year bond is effectively the hurdle rate to judge other investments.

In 1981, the 10-year U.S. Treasury had, believe it or not, a yield of 15%. Today it yields 1.5%. By the old 60/40 approach would an allocation to fixed income be the same, say 40%, when yields were at 15% as when they are 1.5%? Probably not. What kind of allocation to stocks would have seemed reasonable when risk-free bonds were yielding 15%? Sixty percent? Also, probably not when the longterm total return of stocks had been closer to 10%. In fact, when bonds were yielding 15%, asset allocators could have adopted a "TINA" approach, for There Is No Alternative to bonds. In actuality, U.S. stocks outperformed the 10-year Treasury over the following 10 years and then again for the 10 years through 2000. So, clearly there was an alternative.

In portfolios that want to dampen the volatility of a heavy stock allocation, we advocate an allocation to short-term bonds.

The 10-year bond yield obviously cannot be viewed in a vacuum. In 1981 it seemed unlikely that other assets, such as stocks, would outperform a 15% yielding bond. But, stocks were undervalued and they bested bonds. Similarly it seems unlikely that bonds with current yields of 1.5% could possibly outperform stocks today. After all, if stocks outperformed bonds when bonds yielded 15% what are the odds of bonds outperforming stocks when yields are at 1.5%? Strange things happen in financial markets. If

the global economy weakens further and stocks decline, the Treasury bond may prove to have been the better of two apparently poor alternatives-- at least for some period of time.

So where does that leave us? After a ten-year bull market in stocks and a forty-year bull market in bonds with the 10-year risk-free return at only 1.5%, we prefer to still own stocks and only own short-term bonds with the expectation that yields will move higher over time. Currently, the consensus view that yields will remain low for longer is hard to debunk but we are always suspicious of the consensus. So, in portfolios that want to dampen the volatility of a heavy stock allocation, we advocate an allocation to short-term bonds.

Avoiding the Right Church, Wrong Pew Problem

With a heavy allocation to stocks, the total performance of a portfolio will depend on broader market trends as well as security selection. By maintaining a high allocation to stocks at this time, we are aware of what is called the "Right Church, Wrong Pew" problem. In other words, the allocation might prove to be correct--the right church, but actual securities selected disappoint--the wrong pew. This brings us to the second step of connecting actual portfolio holdings with our outlook for stocks and bonds. We are concerned that economic growth and earnings are slowing and that some of our portfolio holdings are not as attractively valued as when they were purchased. As a result, we are looking for companies that are less economically sensitive and have more reasonable valuations. The brief company review of Progressive Corporation below is an example of an investment that we think makes sense in terms of portfolio diversification in this environment.

Progressive is an insurance company that made their name insuring high risk car drivers. Progressive is a rarity in the insurance business in that it actually makes money on the insurance under-

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writing business because their premiums actually exceed their claims and expenses. Many insurers rely on their investment activities to be in the black. Progressive has been a technology leader in the industry, and through an acquisition in 2015, is attempting to become a major competitor in

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homeowner's insurance as well. We think this new opportunity for growth is an exciting opportunity-- exciting as far as insurance can be. As mentioned above, we are looking for companies with less economic sensitivity, and insurers are less economically affected. Insurers have their own cycle, however, that is affected more by price competition and excess capacity than economic cyclicality. It is an example of trying to tilt the portfolio to less economic cyclicality and less valuation risk.

In Summary

Asset allocators never thought they would have to decide how much to allocate to bonds that in some parts of the world have negative yields. We would like to have a higher weighting in bonds, but simply find these yields unacceptably low. As a result, any allocations to bonds are in short maturities with the purpose of dampening the volatility of the portfolio. With the stock allocation we are attempting to moderate risk by adding companies with lower valuations and lower economic sensitivity. We will stay the course with a higher allocation to stocks because yields remain low, and stocks are not excessively valued. Unfortunately, economic weakness is spreading and that is likely to affect stock prices. From an asset allocation point of view we are not in the 60/40 camp or the "Yale" camp. We reject the notion that there is ever only one alternative--the TINA conclusion. Let's call it TANGO, or There Are No Great Options, at least in the short-term.

Bob Milnamow

President and Chief Investment Officer October 2019

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The Standard & Poor's 500 Index is an unmanaged broad-based index that is market weighted and used to represent the U.S. stock market. It includes 500 widely held stocks. Total return figures include the reinvestment of dividends. "S&P 500" is a trademark of Standard and Poor's Corporation. The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the NASDAQ. The Nasdaq Composite Index is the market capitalization-weighted index of approximately 4,000 common equities listed on the NASDAQ stock exchange. The index includes all Nasdaq-listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs) or debenture securities. The Dow Jones Global (ex U.S.) BMI (Broad Market Index) comprises the S&P Developed BMI and S&P Emerging BMI, and is a comprehensive, rules-based index measuring stock market performance globally, excluding the U.S. The Barclays Aggregate Bond Index is a market capitalization-weighted index. Most U.S. traded investment grade bonds are represented. Municipal bonds and Treasury Inflation-Protected Securities are excluded, due to tax treatment issues. The index includes Treasury securities, government agency bonds, mortgage-backed bonds, corporate bonds, and a small amount of foreign bonds traded in U.S.

Important Disclosures: 1. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Adviser has

selected the stated benchmarks to allow the comparison of a client's performance to that of a well-known index. The benchmarks are shown for comparative purposes and to establish current market conditions. Clients cannot invest directly into an index. Clients should be aware that the referenced benchmark may have a different security composition, volatility, risk, investment objective and philosophy, diversification, and/or other investment-related factors that may affect the benchmark ultimate performance results. Additionally, referenced indices may not include fees, transaction costs or reinvestment of income. Therefore, the Adviser's and investor's individual results may vary significantly from the benchmark's performance. Benchmarks used by Adviser are current as of the date indicated and may change without notice. 2. This presentation may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as "believe," "estimate," "anticipate," "may," "will," "should," and "expect"). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements. 3. Historical performance is not indicative of any specific investment or future results. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor. 4. Investment in securities involves the risk of loss of interest and/or initial investment capital. Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Adviser's clients may or may not hold the securities discussed in their portfolios. Adviser makes no representations that any of the securities discussed have been or will be profitable. 5. Nothing in this presentation is intended to be or should be construed as individualized investment advice. All content is of a general nature. Individual investors should consult their investment adviser, accountant, and/or attorney for specifically tailored advice. 6. Any links to outside content are listed for informational purposes only and have not been verified for accuracy by the Adviser. Adviser does not endorse the statements, services or performance of any third-party vendor without specifically assessing the suitability of a third-party to a client's or a prospective client's needs and objectives. 7. Registration with the SEC should not be construed as an endorsement or an indicator of investment skill, acumen or experience.

BARRETT

ASSET MANAGEMENT

90 Park Avenue, 34th Floor ? New York, NY 10016 ? (212) 983-5080 ?

Independent. Customized. Focused.

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