Asset Allocation for 2011

As we approach the end of 2010, the investment environment has changed dramatically. Bonds that have been viewed as the quintessential safe haven in these tumultuous markets are showing negative returns.  

Can you imagine a bond return with a negative sign beside it?  In fact bond returns have been looking weak for a few months now.  November returns for bondholders will start to reflect the true damage that has taken place in this asset class.

In a rising interest rate environment, bonds are the wrong place to be.  As yields continue to climb, bond prices fall in sympathy.  As the U.S treasury continues to face higher refinancing commitments, it reinforces a crowding out effect, so that new issuance must support a higher and higher yields to attract investors.  This reality of higher yields creates a death spiral for bond holders.  Also the corporate news is gradually improving with economic indicators reflecting a slowly improving environment.  

While some investors point to QE2(Quantitative Easing Part 2) as a reason for holding bonds, we do not believe that the purchases of treasuries will be able to hold the dike of willful bond sellers.  As a result, our overall position on bonds is to be at a minimum exposure with an emphasis on short maturities and an emphasis on corporates that are still attractively priced.

On the positive side, we believe that investors in stocks will face a much better year.  As bond holders gradually feel the pain of higher interest rates, stock investors will feel the benefit of this gradual shift of asset mix towards stocks.

At first you will see the results in the attraction towards high yielding securities that offer a dividend tax credit for taxable accounts.  You will also see it in the movement towards stocks that are showing a stronger earnings outlook from an improvement in the overall economy. Many corporations have solid balance sheets and are acquiring other corporations that are reflecting attractive valuations.  

We believe that investors should be at their maximum equity exposure in this environment. Cash should continue to be viewed as a residual in the portfolio. Good hunting in 2011.

Robert Floyd, CFA, is Lead Manager for BirchLeaf Investments (