Allocating Assets Gets Tougher for Investors

Basic asset allocation rules recommend that investors keep their portfolios balanced among stocks, bonds and money-market accounts. The idea is that one of those three will always be working for you.

But there are times when none of those three major asset groups has much, if any, appeal. This may be one of those times.

“I see a paucity of value in financial assets,” said Steven Galbraith, investment strategist at brokerage Morgan Stanley in New York. That makes it tough for him, because he’s charged with telling Morgan clients how best to allocate their money.

Investors’ concerns about the performance potential of stocks, bonds and cash may be leading them to look for other places to put money to work. The housing market seems to be one beneficiary; more consumers also may be more inclined to spend money than invest it.

Here’s what investors face when they consider the near-term merits of each of the three major asset options:

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Bonds: Let’s start here because this has been the best-performing of the three asset classes for the last two years. That has been true, at least, of the highest-quality bonds, such as Treasury issues, bonds of major companies and most municipal issues.

High-quality bonds performed very well in 2000 and 2001 because the economy was deteriorating. Worried investors wanted a safe haven, so they rushed into Treasury securities. What’s more, as the economy weakened, longer-term interest rates began to decline in mid-2000, about six months before the Federal Reserve began to cut short-term interest rates.

Falling market interest rates meant that older, higher-yielding bonds automatically rose in value. The result: Investors enjoyed a “total” return (interest earned plus capital appreciation) of 10.4% on the average government-bond mutual fund in 2000 and 6.7% in 2001, according to fund-tracker Morningstar Inc.

But it looks like bonds’ time in the sun has expired. As economic data in recent weeks have pointed to a surprisingly robust rebound in business activity, many investors have been dumping bonds, betting that interest rates are headed higher. The selling itself has driven market yields higher, in turn eroding the value of outstanding bonds.

The yield on the 10-year Treasury note, a benchmark for other long-term interest rates, rose to a nine-month high of 5.41% on Thursday, before retreating a bit to end Friday at 5.33%. That’s still up from 5.05% at year’s end.

Investors in bond mutual funds enjoyed a good run in January and February, when interest rates still were pulling back. But bond fund total returns have eroded badly in recent weeks. The biggest of all bond funds, the Pimco Total Return fund, now sports a year-to-date total return of 0.5%. Its return had been 2.4% as of Feb. 22, so the give-back has been substantial.

When Fed policymakers meet Tuesday, they aren’t expected to raise their key short-term interest rate, now at 1.75%. But the central bank is expected to nod to the economic rebound by shifting its “bias” on rates to neutral. That would be the first step toward raising short-term rates.

The bond market always anticipates the Fed--hence the whiplash in long-term yields in recent weeks.

Not surprisingly, there is plenty of disagreement among professional investors about the strength of the economic recovery, how much (and when) the Fed might tighten credit, and whether bond investors are overreacting so far this year.

Nonetheless, history shows that a strong economy usually isn’t a friend to the bond market. So the investment outlook for high-quality bonds, for the time being, isn’t encouraging.

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Money-market accounts, or “cash”: Investors who have been parking their dollars in money-market mutual funds, bank CDs and other short-term accounts for the last year have endured the lowest returns in 40 years, as the Fed has held down rates to minimize the recession.

Even though the Fed may be on the verge of raising rates, however, cash accounts aren’t likely to provide dramatically better returns any time soon. For one thing, the Fed doesn’t want to risk raising rates so quickly that it stifles the recovery, most analysts say.

Economists at Merrill Lynch & Co. told clients Friday that the Fed’s first rate increase probably won’t occur until summer--assuming, they said, that the U.S. unemployment rate rises in spring after sliding the last two months. “Politically, the Fed probably won’t tighten [credit] while the unemployment rate is rising,” they said.

Shorter-term market yields could perk up even before the Fed officially changes its benchmark rate. Indeed, six-month Treasury bill yields already have risen from a low of about 1.6% in January to 2.07% as of Friday.

But that isn’t filtering through to money-market mutual funds yet: The average annualized seven-day yield on taxable money funds fell last week to a new record low of 1.35%, according to fund tracker Imoneynet.com.

Most banks, meanwhile, continue to keep a tight lid on CD yields. Nationwide, the average 1-year CD yields 2.21% now, up slightly from 2.13% two weeks ago, according to Imoneynet.com.

The bottom line: Cash accounts pay lousy yields, and they aren’t heading back up to significant levels soon. After taxes and after even minimal inflation, real returns on money funds are negative.

The only good thing one can say for cash accounts is that they continue to offer relative safety compared with bonds and stocks. Whatever you put into a cash account you’re virtually guaranteed to get back, not counting inflation’s effect.

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Stocks: After a rough start this year Wall Street is back in the black, as measured by key indexes.

The blue-chip Standard & Poor’s 500 index is up 1.6% in price year to date. The average New York Stock Exchange stock is up 2.9%.

The Nasdaq market, loaded with technology issues, hasn’t yet climbed out of its bear-market hole: The Nasdaq composite index is off 4.2% for the year, though it has rallied from its February lows.

In general, the equity market seems to be responding positively to the idea that the economy is recovering, which should (eventually) translate into higher corporate earnings. But the almost universal lament of market strategists and money managers is that most stocks aren’t cheap relative to the earnings outlook. That leaves professional stock pickers worried about the market’s ability to hold on to, and add to, its recent gains.

Sung Won Sohn, economist at Wells Fargo & Co., sums up the view of many pros: “The best time to buy stocks is in the middle of a recession,” he notes. That was last fall. Now, “The market is in the riskier phase of the bull market. Valuations are lofty” given the rebound in share prices since September while earnings remain depressed, he said.

Investors’ apprehension has made for a volatile market, where bouts of heavy profit-taking can quickly follow sharp price gains. “I see investors being much more disciplined sellers now,” said Morgan Stanley’s Galbraith.

What’s more, the ongoing weakness in technology, biotechnology and telecom is weighing on many mutual funds that had picked up shares in those sectors last fall. That helps explain why the average domestic stock fund’s gain so far this year is a mere 0.4%, according to Morningstar Inc.

If the economy is in fact on the mend, the stock market ought to have a far better chance of producing good returns this year than the bond market or cash, many pros agree. But many also agree that this could be a classic stock-picker’s market--meaning that those who pick well can win big, and those who pick poorly can lose big. In other words, there’s substantial risk out there.

Of course, for investors truly focused on the long-term, none of these near-term concerns may affect their asset-allocation decisions. But if your sense has been that this is a particularly frustrating period to be making money choices, there may be at least some comfort in knowing that that view is widely shared.

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Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, go to: www.latimes.com/petruno.