PERSONAL FINANCE Asset Models Say Worst Is Over, But Stocks Are Still Overvalued
April 03, 2011
NEW YORK -- Several tactical asset allocation managers believe -- based on their models -- that the stock market remains slightly overvalued to the bond market. These TAA managers, as they are known, are opportunistic investors who take their models of the market, plug in all kinds of economic and market data and use the results to determine whether a certain class of assets is overpriced or underpriced. Many of them run money for pension funds, aiming to help them take advantage of market inefficiencies. ``We've actually been waiting for some months now for this kind of correction,'' says Maxwell David, a director at First Quadrant Corp. in Pasadena, Calif., which uses TAA strategies to invest about half of the $12 billion in assets under its management. ``We had switched to a view where we preferred bonds over stocks, primarily because of our bearish view on stocks rather than because of our bullish view on bonds.'' First Quadrant remains negative on the stock market and slightly positive on the bond market. Numeric Investors L.P., a quantitative investment firm in Cambridge, Mass., with a TAA model under development, believes the stock market remains about 5% overvalued relative to the bond market. But that's closer than the 10% to 15% overvaluation the firm's model showed before stocks began to sell off last week. ``We're moving up to a level that's a little overvalued, but the goofy valuation that built up in May and June has clearly run its course,'' says Gaskin Oliver, the company's president. What concerns him now is that the market usually overreacts before reaching equilibrium, meaning the sell-off could continue until stocks are actually undervalued relative to bonds. But, he says, ``this could be different. Maybe for the moment, the nervous people are accommodated.'' TAA specialists fill their models with variables ranging from market prices to economic indicators. Edison Kelli, chief investment strategist at Panagora Asset Management in Boston, also looks at market volume and volatility -- factors that were indicating earlier this month that a sell-off could be imminent. Volume declined as volatility grew, which is a sign of a market vulnerable to a shake-up, Mr. Kelli says. Panagora's benchmark TAA allocation now calls for a 50% weighting in stocks, a 34% weighting in bonds and a 16% cash position. A ``normal'' allocation would be 60% stocks and 40% bonds. Another technical factor in addition to volatility and volume that drove the reallocation was the rate of growth in earnings expectations. Just before the sell-off, earnings estimates by Wall Street analysts were running 38% higher than they had been a year and a half earlier. That suggests a feverish market -- a 12% rise would have been closer to normal. Mr. Kelli is reassuring about Panagora's underweighting in both stocks and bonds. His reasons are more technical than fundamental, he says, and the long-term outlook for the markets is good. If Panagora were truly bearish on the market, it would be recommending a stock allocation of perhaps 30% -- in a TAA strategy, a sector allocation can go all the way down to zero. For now, Mr. Kelli says, ``we have an overbought environment. That's only short-term.'' The sort of fundamental change that could make it long-term would be, for example, a tightening of monetary policy by the Federal Reserve. If the Fed were to raise short-term interest rates, the bond market likely would rally, sending most rates lower and prices higher. This would prompt Panagora's TAA model to overweight bonds and underweight stocks. Panagora uses its TAA model to manage 43 institutional accounts. Before triggering a trade within an account, Panagora calculates the optimal allocation for that account and then looks as the actual allocation. A 6% difference triggers a trade, Mr. Kelli says. First Quadrant's Mr. David says his company's TAA model focuses on whether the market is overpriced, not when to buy or sell. ``That's much less clear to us,'' he says. Still, factors the model analyzes can help indicate the market's direction. For instance, if bond yields were to rise quickly, ``we would expect the overpriced equity market to correct fairly quickly.'' If the market remains where it is, Mr. David would expect stocks to perform poorly until the stock and bond markets reach equilibrium. First Quadrant's models examine relative spreads between bond yields, as represented by the Lehman Aggregate Index, and earnings yields in the stock market. The models aim to strip out the cyclical component of earnings -- to get a more long-run view -- and compare those yields to the yield on three-month Treasury bills. ``It's a dynamic process which looks at the stresses and strains between yield spreads,'' Mr. David says. The model also considers economic measures and what are called ``sentiment measures.'' Volatility is one of those -- it moves with the changing perception of risk in the market.
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