Overweight Equities, Underweight Bonds ~ market folly

Thursday, January 14, 2010

Overweight Equities, Underweight Bonds

Bank of America Merrill Lynch is out saying to overweight equities and underweight bonds. Their Research Investment Committee (RIC) says that long-term investors should buy 'humiliation' and sell 'hubris,' noting that equities are currently a 'humiliated' asset class. They attribute this classification to the past ten year performance of large cap equities, a period where these assets performed worse than in the 1930s. They write, "on a relative basis they have clearly suffered the greatest ignominy over the past 10 years and despite the rally of the past nine months remain the most unloved and undervalued asset class." Hedge funds would certainly agree with the notion to get long equities as they've had considerable net long exposure for some time now.

Why To Buy Stocks

In BofA's allocations, they are beefing up equities holdings from 60% of the portfolio to 65%, while reducing bonds from 35% down to 30%. They argue that stocks are cheap relative to both government bonds and corporate bonds, citing equity risk premium ("a measure of excess return of the S&P 500 earnings yield minus the yield of 10-year TIPS"). See the chart below for an illustration of this measure:

(click to enlarge)

Additionally, they cite that investors are clinging on more to fear than greed in regards to sentiment toward equities. This is evidenced by massive inflows into bond funds in 2009 and selling of US equity funds over the course of last year.

Lastly, Bank of America Merrill Lynch argues that equities should see more favorable returns than bonds in 2010 because there has been a transfer of balance sheet risk from corporations to the government. Specifically speaking on equity strategies, they are overweight energy and industrials. Additionally, they favor large financials (market caps > $20 billion).

International Equities Versus US Equities

In their report (focused on asset allocation strategies), we see that they recommend more international exposure because investors have what they call "investor home bias," a condition where investors often have considerable home-country holdings and only modest amounts of foreign exposure.

Secondly, their Research Investment Committee argues that emerging markets have not yet reached 'hubris' status. They would be worried about emerging markets once multiples start to climb as high as 48x forward earnings like we saw during the tech bubble. (The MSCI Emerging Market Index is only trading at 13x P/E ratio). Turning to implementation, they recommend investing in Asia and emerging market consumer stocks. Additionally, they are overweight 'best of breed' global financials (and in particular those in Brazil, China, and Europe). Below you'll find a breakdown sheet outlining their global equity market convictions and ideas:

(click to enlarge)

As you can see, they are taking a bit of a contrarian approach to the investing public's moves in 2009. Last year, investors flooded into bond funds and out of stocks. They clearly feel that valuation and potential returns favor equities in this year and are looking for investors to move to the other end of the teeter-totter, balancing things out. This wraps up the recommendations from Bank of America Merrill Lynch's Research Investment Committee. We just recently covered BofA's hedge fund investment trends report as well as their research on the top ten stocks held by hedge funds, so make sure you check those out too.

For more investment ideas for this year, we've compiled plenty of resources including:

- Analysts' best stock picks for 2010

- Ten investment themes for 2010

- Market strategist Jeff Saut's 2010 outlook

- Hedge fund manager Doug Kass' 2010 predictions

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