The Fixed-Income/Equity Choice

The Fixed-Income/Equity Selector

Victor A. Canto and Christian Carrillo

In an attempt to keep track of the value added of our recommendations, we have devised a simple procedure that compares the performance of a balanced portfolio that is 40% allocated to 10-year T-bond and the rest to the S&P500. We then adjust the weight of the components of the balanced portfolio in proportion to the estimated likelihood of fixed income outperforming equities and vice versa. The estimated probability that the S&P500 will outperform the 10 year T-Bond yield is reported in the first row of Table 1. The quarterly performance of the benchmark “balanced portfolio” and the LJE recommended allocation can be seen in the second and third rows.

Table 1

Probability Estimates of Stocks Outperforming Fixed Income

and

Portfolio Performance

*as of 9/21/00

The Third-Quarter and Year to Date Performance. At the beginning of the quarter we argued that the market’s expectations were consistent with our view that the hump in the yield curve would migrate to the short end and that rates are going to decline by year end. We also believed that the long end of the yield curve would back up somewhat and that there was a better than 60% chance that the notes and 10-year bond would outperform the T-bill during the third quarter. We put the odds at less than fifty percent that the equity markets would outperform the fixed income market during the third quarter. Much of what we expected occurred. The yield curve inverted fully, the 10 year T-Bond outperformed the T-bills and the equity markets under-performed the bond market.

For the quarter the benchmark appreciated 1.24%. Since our forecast called for the S&P 500 to under-perform , we reduced the equity exposure of the LJE model portfolio. The LJE allocation produced a 1.42% gain during the quarter, beating the benchmark by 18 basis points. For the year the LJE advantage is smaller, the LJE strategy is leading the benchmark by 6 basis points.

The Fourth-Quarter Outlook . The futures market expectations have changed dramatically in the last few days. We now look for the short end of the yield curve to hold steady until the end of the year and to decline steadily all of next year. The long end is also expected to rise approximately 25 basis points over the quarter. Over the next quarter we estimate the probability of the long end of the curve outperforming the short end to be slightly better than 50%.

The outlook for the fixed income securities is a mixed one. The economic slowdown , the weak euro, the high oil prices and the realization that the public debt will not disappear have rattled the bond markets. We have a slightly different view than most people. The rise in oil prices will not be inflationary as long as the U. S. is on the price rule. The effect of the oil price will be analogous to a tax that will slow down the economy and produce disinflationary pressure in the non-oil sector of the economy. The big issue is whether Al gore or George W. Bush will be elected. That we will find out in November. In the meantime, our model suggests that as the year comes to an end the likelihood of the equity market outperforming the fixed income market increases substantially.

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