Posted by: Daryl & Wendy Ashby | February 21, 2010

David West Speaks

Today I’m going to make a forecast for the two main asset classes for 2010. It will, of course, be wrong.

What good is a forecast, you might ask, if it’s destined to be incorrect? The answer lies in the belief that having some kind of a plan, faulty though it may be, is better than having no plan. If you don’t have a sense of where the market is headed, you won’t be able to adjust when the market fails to go where you predicted it would go, because you won’t know it’s not going where you thought it would, if you get my drift.

To say the same thing in another way, early in my career I was counseled to never not have an opinion on the future direction of the market. Even if it’s wrong, which it will be, you’ll at least know it was wrong, how wrong it was, and why. That way your forecasts have a better chance of improving in accuracy over time, and your portfolio should perform better.

Another thing about making forecasts: they don’t have to be elaborate and intricate. It will suffice for you to decide whether the market will go up or down, and by a lot or by a little. You can read all of the elaborate and intricate forecasts put out by all the major brokerage firms, and then consolidate them into one quick and dirty, big-picture forecast of your own. Up or down, and by how much. That’s all you need.

Here, for better or for worse, is my forecast for 2010, by asset class.

Cash
Right now we have a target overnight interest rate of just 0.25%. Expect it to hold at that level until at least June, and possibly to as late as September. Expect it to then start ratcheting up to perhaps 1.00% by the end of the year.

What does that mean? Cash plays two main investment roles in a portfolio. One is to dampen the overall volatility of a portfolio. We can expect some volatility especially in equities this year as the economy recovers but does so in fits and starts. You want some cash in your portfolio this year to dampen that volatility.

The other role cash plays is to provide next to no return after inflation and taxes. That’s a good thing when stocks or bonds produce negative returns, neither of which we expect to happen this year. Thus you probably don’t need to hold any cash right now for that purpose.

You also need to carry cash for non-investment reasons such as fees, commissions and so forth.

Bottom line: if you normally carry between 5% and 10% of your portfolio in cash, this year you’ll probably want to hold closer to 5%, for volatility reasons and not for performance reasons, as explained above. You also probably want to keep terms very short, e.g. 30 days or 60 days and rolling over as rates begin to rise through to year-end. Use term deposits as opposed to treasury bills or money market funds.

Fixed income
Both bonds and preferred shares have had a couple of good years as interest rates fell to historic lows and, especially for corporate bonds and preferreds, as credit spreads collapsed.

We can’t expect near the same performance this year, especially as interest rates are poised to start rising. The credit spread still has a ways to come down, though the big money has already been made.

Bottom line: you want to keep durations very short, i.e. you want bonds with high coupons and short terms to maturity. Expect government bonds to return equal to or a bit less than their coupon rates. Expect corporate bonds to return slightly better than their coupon rates as the credit spread comes down further. The proportion you have in preferred shares vs. corporate bonds depends on your personal tax situation. You probably want to have a higher proportion of corporate versus governments, say a 60%/40% split. Overall, you probably want to underweight fixed income this year relative to what you normally carry. For example, if you normally have 40% of your overall portfolio invested in fixed income, this year you might have 35%

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