U.S. small caps are 88% correlated with U.S. large caps. Value, with 90%. Growth, with 95%. Foreign stocks (the MSCI EAFE index), with 86%. Even emerging markets are 72% correlated.
What's not highly correlated are real estate (21%), hedge funds (26%), equity market-neutral funds (26%), and commodities (11%). Granted, real estate may not be the ideal diversifier to use right now.
A conclusion that RegentAtlantic in Chatham, N.J., has reached is that it should beef up its clients' exposure to alternative investments.
Speaking recently to members of the Ridgewood Investors Club, Brian Kavanchy, CFP, CFA, MBA, of RegentAtlantic said that the correlations were tracked over a ten-year period, from June 30, 1997 to June 30, 2007, by JP Morgan. (I thought it was interesting that hedge funds and market-neutral funds turned out to be blood brothers.)
In his talk Kazanchy said that for 2008 his firm isn't veering much from its asset-allocation strategy for 2007.
The following percentages are the firm's 2008 asset allocations - and how they differ from the firm's standard allocation. (The standard allocation would apply only if RegentAtlantic thought all asset classes were fairly valued.)
The fixed-income allocation consists of 40% short-term U.S. bonds (vs. a standard allocation of 35%), 25% in hedged international bonds (vs. 20%), nothing in high-yield bonds (vs. 10%), and 35% in inflation-indexed bonds (same as standard allocation).
High-yield bonds, Kavanchy believes, aren't currently paying enough vis-à-vis Treasuries for their added risk.
In general, RegentAtlantic avoids long-term maturities, believing that short- and intermediate-term bonds provide almost the same returns, but with much less volatility.
As for stocks, there the asset allocation for global large stocks has gone up a bit (it will be 65% vs. a standard allocation of 60%), U.S. small stocks will be 10% (standard is 15%), international small stocks have remained the same (12.5%), and emerging markets will be reduced to their standard allocation of 12.5%.
Why the lower exposure to small caps? "They look richly priced."
As for alternative investments, real estate in the model portfolio has shrunk from 30% to 5% (mainly remaining in foreign real estate), commodities risen from 30% to 40%, and hedging strategies climbed from 40% to 55%. But the hedging vehicles that used, Kazanchy stressed, are "super-conservative."
What industries or areas look especially attractive? Timber, private equity, and infrastructure. What about health care? He likes managed health care companies, like Humana and Wellpoint.
As for India and China, he noted that their gross domestic products are climbing faster than ours (U.S. 3.8%, China 11.5%, India 9.3%), and their populations are younger. Average age in the U.S.: 36.6; in China, 33.2; in India, 24.8.
I asked him: If he were in a stock-picking contest, which stocks might he choose now? Answers: Lehman Brothers, although it's been "beaten up," is a well-run financial company, and ConocoPhillips, an integrated oil company whose srock should continue to do well, despite its run-up.
As for the economy in general, housing and subprime mortgages are worrisome, but low unemployment and robust corporate earnings suggest that "We have a good chance of avoiding a recession. The Fed is doing a good job."
Kavanchy mentioned another reason to worry, though. Consumers didn't bother to save when housing prices went up and up. Now that they are going down, consumers may cut back on their spending and start saving more – and their spending has kept the economy humming.
On the other hand, current price-earnings ratios – of around 18 for the S&P 500 seem reasonable. "The market looks fairly priced."