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In the beginning of 2008, while facing a global economic crisis, our stance on the asset allocation between bonds and equities was ‘neutral’. For our recommended portfolios, after being bullish for quite a while and being overweight on equity, we reduced our weightage on equities at the end of 2007 resulting in a neutral allocation between bonds and equity. But that was not enough to shelter our portfolio from the financial storm. Both equity and bond funds have fallen with heightened risk-aversion driving investors away from the shares and credits of companies. Refer to an article named ‘Why A Diversified Portfolio Still Lost Money in 2008’ for more.

Probably the only portfolios that have gained in 2008 would be those that invest in global bond funds that overweight G7 treasuries or bonds. Or alternatively, it would be the portfolios of investors that park a large part of their monies in a money market fund or their savings deposit. But going forward, we think that it does not make good sense to have a major overweight position in Cash.

Our recommendation for 2009 would be to overweight equities and underweight bonds and cash. Let’s break this up into several bite-sized portions.

How much cash is sufficient for the average investor?

When you think about forming an investment portfolio, the first thing that would be on your mind would be to leave a portion in cash. This is a logical decision because you will need some liquidity to account for cash withdrawals related to necessary monthly expenditure (for example, your electricity bills, petrol expenses, Christmas shopping etc.). We think that it is necessary to think through your liquidity requirements before starting to invest. A good rule of thumb would be to save 3 to 12 months of your monthly expenditure, depending on how risk averse you are. If an investor’s monthly expenditure sums up to $2000, $6000 to $24,000 would be a good amount that he or she could have in his or her deposit accounts. Of course the more averse to risk you are, you would be more slanted towards putting aside 12 months worth of spending money as a buffer.

There is an opportunity cost to bear, however, if you choose to deposit more than what you need in such a deposit account. Say if you place double the amount you need (let’s take the maximum of $24,000 as an example) or $48,000 in fixed deposits that earns 1% per year, there is an opportunity cost borne by the $24,000 that could be placed elsewhere, earning better returns, especially over the long term.

Based on a recent article that studies ‘How Long Is “Long Term”’, we studied the historical probability of getting positive returns. One of the tables shows us that for a rebalanced equity portfolio (from 1974 to 2008), the probability of getting a positive return over multiple 10-years periods is 96.2%. Another finding is that for such a portfolio, the average annualized return is 10.9%. So we tested out how much $24,000 could earn over different time horizons if the return earned ranges from 1% to 10%. Comparing a 1% return versus a 5% return, the $24,000 earns $5,406.52 more over 5 years.

One thing to note, however, is that this is a simplified example. If you had invested into a portfolio of funds in 2008, you would rather wish to see a small positive return than a huge loss. But loss aversion fades away once you think of investing for the longer-term. So, in this article, when we talk about sufficient weightage in cash, it means holding 3-12 months worth of expenditure in liquid assets and investing the excess that you don’t need.

So the first point would be that, it makes sense to have sufficient not excessive cash in your portfolio depending on your liquidity needs.

Why not overweight cash tactically in 2009?

The second point that I would like to make is that cash or near cash is a good option when equities are expensive and markets are at a high and crashing down quickly. But holding excess-cash when interest rates are at record low levels just may not make good sense. We all know that the Federal Reserve has cut interest rates from 5.25% (September 2007) to 0-0.25% (as at 17 December 2008). The level of aggressiveness in rate cuts shows how urgently the Federal Reserve wants to take on an expansionary monetary policy to stimulate the US economy. The data that we have plotted on chart 1 shows that the 12 month Fixed Deposit rates (sourced from DBS) and the SGD Interbank Offer rates (SIBOR) are close to their lowest levels in the past 10 years.

The 12 months fixed deposit rate for deposits of less than $50,000 is at 0.825%, lower than the 10-year average of 1.25%. The SIBOR rate is 1.0625% (as at end November 2008), much lower than the 10 year average rate of 2.224%. This is not surprising given that there has been a lot of risk aversion as investors move away from equities and corporate bonds into the money market creating abundance in liquidity. The liquidity we see are largely deposits parked in safe instruments such as fixed and savings deposits, which are 12 months or below. With this abundance of liquidity, there is little incentive for banks to raise deposit rates to attract additional capital.

Short term rates in Singapore will remain low in the medium term. The yield for Singapore government bonds (SGS bonds) with maturity of 1 year was at 0.73% (end November 2008). Given that these are almost riskless bonds issued by the government, deposits by banks should only command a very slight premium (given that the Singapore government is providing a guarantee on deposits till December 2010).

Although interest rates are at low, investors should still consider a portion (3 months to 12 months worth of monthly expenditure) to be in deposits or similarly liquid and safe assets. With the rest of the funds, equities and bonds look more attractive than cash at this moment.

But if we compare equities and bonds, which one should we choose?

Equities versus Bonds for 2009

When we compare equities versus bonds for individual countries, we often use a model that compares the earnings yield with the government bond yield of the same market. This model believes that earnings yield of the market (represented by the reciprocal of the market price earnings or PE) shows the percentage of each dollar invested in the stock market earned by the market itself. So if the PE is 16X, the earnings yield is 6.25% and every dollar invested gives you an inherent return of 6.25%. If earnings yield is much more than the government bond yield, stocks as a whole can be considered as undervalued. Earnings yield usually would be higher than bond yield simply because of the risks accompanied with owning stocks, and investors should demand an extra risk premium above owning a risk-free government bond.

Table 2 shows us that aside from Indonesia, the rest of the Asian markets have a high excess earnings yield over bond yield. In particular, the Asian country markets which are the most attractively valued including Thailand, Singapore, Malaysia and China.

Table 2

Chart 2 shows us that in comparison to the average 5 year yield of the government bonds of four Asian countries including Singapore, Hong Kong, Taiwan and Korea, Asia’s earnings yield levels are much higher. As at 19 December 2008, Asia ex-Japan has an excess yield of 8.6%, compared to the average excess yield from 1999 to 2008 of 2.46%. PE ratios are now at very attractive levels; if you translate this to earnings yield, it becomes more obvious. Investors should take note, however, that excess earnings yield at this point of time would naturally be higher during this crisis as the market is pricing in a high risk premium in equities. The point we are trying to show here is that earnings yield is much higher than bond yields for Asia ex-Japan and equities are a comparatively better bet at this point of time.

Aside from the higher earnings yield figures, we also find that dividend yields for Asia are at attractive levels. The dividend yield is 4.5% as at 19 December 2008. Dividend yield here is defined as the sum of gross dividend per share amounts (for shares that has gone ex-dividend), divided by the current stock price. So a high dividend yield means either dividends being paid out are high in comparison to the current stock price or prices are very depressed. In our case, the latter would sound more reasonable. Chart 3 shows that dividend yield has reached a 52-week high on 25 November 2008 of 5.77%. Since then, Asian equity markets stabilized and dividend yields have gone down again to 4.5% (19 December 2008), still higher than the average of 2.66% (data from 1995 to 2008).

Corporate Bonds is Attractive for Investors

With these factors in mind, we have decided to overweight equities versus bonds in 2009. What this means to investors would be that from the current neutral weighting on equities versus bonds, we will go overweight on equities, according to the different investor risk profiles. Table 3 shows the target weightage we would have for our recommended portfolios.

Table 3

From table 3, you would probably have noticed that unless you are an aggressive investor, there should be a portion invested in bonds. In that area, investment grade corporate bonds look attractive right now.

Over the past year, government bonds of developed nations benefitted the most as investors fled from risky assets in the current economic conditions. The yield on shorter-term 3 month Treasuries are now next to nothing. Yields on corporate bonds and emerging market bonds have soared from a year ago. The current difference in yields of Treasuries and corporate bonds (also know as yield spread) are near record wide levels. Chart 4 shows the spread of the lowest rated investment grade bond – BBB bonds against Treasuries.

We believe that extremely low yields on Treasuries as compared with high yields on corporate bonds would entice investors back into investing into corporate bonds. While both investment grade and high yield bonds are attractive from the perspective of relative yields to Treasuries, we prefer investment grade bonds as we believe risk appetite would first recover for investment grade bonds before subsequently benefiting the more volatile high yield bonds. In fact, in the past two recessions, risk adjusted returns for investment grade bonds have been better than high yield bonds.

Risks in overweighting equities

We think that although downside is limited for equities, there are still risks that linger in 2009. The first risk would be that government bailout packages may not be able to stimulate spending in the various economies and consumption continues to slide, affecting global demand.

Secondly, the financial sector in the US is strained due to the drying up of credit liquidity. The fear is that credit related issues are brought over to 2009. Even when policymakers continue to inject liquidity into the markets, credit markets still remain strained. With credit markets strained, the worry is that businesses which require borrowings to fund current expansion plans are not able to get any. This trickles down to poorer levels of consumption spending as well when it is more difficult to get bigger loans to finance purchases of property or vehicles etc.

Thirdly, there is the risk that global economic growth (inclusive of fast growing Asia and Emerging Markets) falls close to 0% in 2009, which will not bode well for investment sentiment worldwide. So far, there has only been one institution that has forecasted the global economy to contract in 2009. The Institute of International Finance says that the global economy will contract by about 1.4% in 2009 with economic activity especially weak in the first half of the year. If the weakest or most pessimistic forecast of a global recession comes through, risk levels of investing into equities will remain high even in 2009.

Things to bring back

As we come to the end of 2008, what we can look back at would be a year ‘full of reds’. Market are in red and investors are fuming red over losses in their portfolios - it is little wonder that it’s difficult now to imagine oneself investing or overweighting the asset class that has crashed the most. But, the truth is that equity valuations have really gone to very attractive levels. In fact, investors who have closely monitored equity markets would have noticed that since global equities reached a bottom during the end October to beginning November period in 2008, markets have stealthily gained pace. For example, MSCI Asia ex-Japan has risen 29.6% (in USD terms) from 27 October to 19 December. Singapore’s Straits Times index (STI) delivered a return of 12.2% since then as well. We will be covering more of how markets performed after the October/November bottom in a separate report.

Our favourite region for 2009 would be Asia ex-Japan; the recommended funds that we have for this region include Aberdeen Pacific Equity and First State Asian Growth Fund. Our favourite Asian country for 2009 is China, with First State Regional China Fund and HSBC GIF Chinese Equity as two of our recommended funds. Do note that regional funds including Asia ex-Japan, US and Europe etc. falls into the core portion of your portfolio and Asian single country funds fall into the supplementary portion.