Covestor

July saw a sharp turnaround in the markets, as the Fed’s pledge to keep money free for the foreseeable future combined with generally solid earnings reports to convince investors it was safe to venture back into the risk pool. The bond market, however, is telling a different story, and when that happens, it is more often than not the stock markets story that turns out to be fairy tale. As of August 4, 2010, what the bond market is telling us is 1/2% per annum is an acceptable return over the next two years, and sub-3% is ok for 10-year money.  And this in the face of $trillion+ deficits as far as the eye can see. Of course this story does not have a happy ending, as the only environment in which this makes sense is one of debt deflation and little if anything in the way of economic growth.

From a valuation standpoint, while current and projected earnings may make stocks appear reasonably valued, a longer term perspective once again tells a different story. One valuation measure we pay particular attention to is Professor Robert Shiller's Cyclically-Adjusted P/E (CAPE), which compares current price to average earnings over the past decade. The current reading places current stock valuations significantly above the long-term average. Given the significant economic uncertainty we face, we question whether such a premium is warranted.

While we believe stocks to be overvalued generally, we do see value in high quality, large domestic companies. We have found the Vanguard Dividend Appreciation Fund (VIG) to be a good proxy for this sector, and have used it for a large portion of our domestic stock allocation. The remainder of our domestic stock allocation is in the Powershares S&P 500 Buy/Write Fund (PBP), which writes covered index calls against the fund portfolio. The strategy provides a partial hedge to our stock exposure, generates income and takes advantage of market volatility. We remain underweight foreign stocks, and may look to reduce our allocation further should markets continue to rise.

We recently added the JPMorgan Alerian MLP Index ETN (AMJ) for stability and income. However, the fund has rallied significantly since our purchase on May 6, 2010 at $27.50 and is now at least fully valued in our estimation. As a result, we sold the position on August 4, 2010 at $33.66.