For several quarters we have been writing about metrics that will portend the eventual economic contraction marking the end of the current expansion, which is just shy of becoming the longest in history. Those metrics include 1) the narrowing of the spread between long and shorter term interest rates and 2) the year-over-year growth rate in U.S. non-farm jobs. As Darcy Nelson Smoot said in our recent video, “End of the Bull Market?”, trying to predict an economic downturn and its associated bear market is a bit like trying to predict when an earthquake will happen. We know one is coming, we just do not know exactly when. Knowing that the ground in California will eventually shake, we prepare by strapping down water heaters, bolting foundation framing, supporting shear walls and making other structural engineering improvements. In a portfolio, the analogous change one should make is to immunize it against the need to make capital withdrawals over the period of time that it typically takes the markets to recover, which is about four years on average.

The near 20% decline in the fourth quarter of last year was a reminder that it is important that we do this now, especially considering the high equity allocations in many of our portfolios. After the prolonged bear markets and high inflation of the 1970s, most of our clients had less than half of their assets in stocks during the 1980s. With real rates at historically high values at the time, most of our clients made as much or more money in the bond market during that decade. From 1980 to 1993, bond yields declined steadily. By 1995, most of our client portfolios were allocated to equities at 60% or more. From 1995 to 2000, with stocks—particularly growth stocks—roaring, average allocations rose with the market to 80%+/-. We reduced average equity allocations to the mid-70% range by the time the dot-com bubble burst.

Equity allocations averaged 60% to 65% in the years between the end of the dot-com bubble and the beginning of the financial crisis. The Fed lowered rates during the financial crisis of 2008-2009, and for the last decade, fixed income assets have barely offset inflation. In fact, equity dividend income has exceeded fixed income yields for most of the last decade. Consequently, many of our clients have equity allocations between 80% and 90%. For most of us, this is too high, and needs to be corrected, first to immunize against capital needs as described above, and then to adjust the remaining assets to one’s risk tolerance. With money fund and bond yields back at or above inflation and stock yields, we can reduce equity allocations without detracting from income production.

Individual investment positions detailed in this post should not be construed as a recommendation to purchase or sell the security. Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Employees and/or owners of Nelson Roberts Investment Advisors, LLC may have a position securities mentioned in this post. Please contact us for a complete list of portfolio holdings. For additional information please contact us at 650-322-4000.