Home Brokerage A Simple Framework for Multi-Level Investment Decisions

A Simple Framework for Multi-Level Investment Decisions

by internationalbanker

By Bob Homan, Chief Investment Officer, ING





Active investors can try to beat the market in different ways. Excess returns, or alpha, can be achieved through asset allocation and instrument selection. First, you decide on the top-down asset allocation: Do you invest more or less in stocks, bonds, cash and their alternatives in your portfolio, according to your current views? Second, you choose which regions, sectors and styles to give more or less weight to in your equity portfolio and the interest rate (duration) and credit risk in your bond portfolio. Third, you select which stocks or bonds to buy. The first two steps can be determined by using a simple framework. In this article, I will discuss this framework by highlighting four factors and then outline my current views. The four factors are economic growth, interest rates, valuations and sentiment.

Economic growth

Let’s start with economic growth, which is important because it ultimately determines corporate-earnings growth. Usually, stock prices fall leading up to and at the beginning of an economic (and therefore earnings) recession. For top-down asset allocation, accelerating economic growth is, therefore, a positive element for equity markets. This year, we expect a slight growth slowdown for the global economy, particularly in the United States, where growth remained surprisingly strong last year. Subsequently, you can look for the region with the best relative growth prospects and steer towards it in tactical asset allocation. For example, the relative growth differential between faster-growing emerging markets and developed markets has narrowed in recent years, resulting in the underperformance of emerging markets’ equities. This growth differential is expected to increase again in the near future.

However, in the really long term, demographics and productivity growth, driven by technological developments, play the biggest role in economic growth. Looking at those variables, the US seems able to maintain its strong position. Investors can do the same at the sector level: Where are profits growing fastest? Each sector increasingly has its own cycle. The cyclical sectors are still fully linked to the economic tide, but sectors such as semiconductors sometimes go right through it. For this year, I think IT (information technology) and related sectors are riding the tide. For long-term profitability, look at societal trends. Even then, IT-like stocks will surface, but also consider the industrial sector, from which many solutions to the climate problem will come.

Interest rates

The second important factor is the interest-rate factor. The so-called risk-free interest rate is the reference point for all investments. In Europe, we usually take the 10-year yield on German government bonds as our benchmark. When the risk-free interest rate—or base rate—rises, the return you demand on other (riskier) investments will also automatically increase. Therefore, low or falling interest rates generally support all asset classes. This revaluation works most directly for government bonds, whereby falling interest rates immediately lead to increasing bond prices. This year, the door to lower interest rates seems open. In the most likely scenario, based on slowing inflation, central banks are expected to cut their policy rates. And although long-term interest rates have already discounted this scenario, I think they could come down somewhat more.

The interest-rate factor is thus positive for financial markets in the coming period. Over the last two years, the volatility in sovereign bond markets has increased sharply. This increased volatility may continue for an extended period due to geopolitical tensions, climate change and demographics (an aging population leads to a lower money supply), amongst other reasons. This means bonds are somewhat riskier than in the past, even relative to other asset classes, arguing for a lower weight of bonds in a mixed portfolio. As mentioned, interest rates are important for each asset class.

The relative importance of the interest-rate factor on the price of an asset class decreases when the asset class becomes more influenced by the other three factors. Besides economic growth, there are valuations and sentiment, to which I will return later. After government bonds, other bond categories, such as investment-grade and high-yield corporate bonds, are the closest to these other factors. In addition to the risk-free interest rate, the price of these bonds is determined by a premium for credit risk, the so-called spread. Obviously, this is company-specific, but for the whole category on average, this spread will change with economic developments, valuations and sentiments. All four distinct factors affect each other. In particular, the relationship between the interest-rate factor and the next one, valuations, is strong.


The valuation of a financial instrument indicates how much you pay for that stock, bond or other instrument based on an underlying characteristic. For example, how many times earnings, cash flow or book value do you pay for a stock? Or, in the case of bonds, how much extra interest do you get on average for a given credit risk? A common valuation measure for equities is the price-to-earnings ratio (P/E ratio): How many times earnings do you pay for a stock? Currently, for global equities, it is about 16.5 times. Is this high or low? Based on history, the valuation of global equities is a fraction above the historical average of 16 times 12-month forward earnings. So, the current valuation is neither cheap nor expensive. Figure 1 shows the price-to-earnings evolution over the last 30 years.

If we look one level lower, we see interesting differences. The valuation of the US stock market is around 20 times earnings, while the European stock market trades at 12 times earnings. The latter figure also applies to the average of emerging markets’ equities. Now, valuations or valuation differentials hardly matter in the short term, but in the long term, they do impact expected returns. From that perspective, European and emerging markets’ equities are relatively interesting. Looking at bonds, the spread on corporate bonds, high yields and emerging markets’ debt is below the long-term average. So, risky bonds are firmly valued. From that point of view, you should currently underweight them. But I don’t think you should. After all, you’re still getting an extra return, and the balance sheets of these specific companies also seem strong relative to the historical average. Indeed, the balance sheets of the obvious alternative, government bonds, seem weaker. Investing is a relative game, after all.

Speaking of relativity, when you combine valuations with interest rates, you get an indicator that is more useful in the short run in determining the relative attractiveness of equities versus bonds. When you take the inverse of the P/E ratio, you get the earnings yield on stocks. When you compare this earnings yield with the interest rate on government bonds, you get the so-called risk premium on equities. Figure 2 shows the development of this equity risk premium. I took the average earnings yield of the world equity indices minus the average government bond interest rate of the major blocks. At 3.9 percent, this number also moves around the long-term average, so for the short term, a neutral weighting of equities versus bonds seems justified.


Unlike valuations, the fourth factor is a shorter-term indicator. And I actually mean a contrarian indicator, because that is what sentiment is. After all, bullish investors have probably already bought into the market and thus could be the next sellers. On the other hand, the investor who tells you the investment climate is bad probably no longer has a position himself and, thus, on balance, could be a buyer in the market. There are several sentiment indicators, including the well-known “Bull-Bear Survey” (the AAII Investor Sentiment Survey) of the American Association of Individual Investors (AAII). And several financial websites, such as CNN’s, have their own sentiment indicators. Right now, these sentiment indicators are quoting high and pointing at bullish investor sentiment. The sentiment indicator works best at extremes. Especially when sentiment is extremely bearish, it is a reliable contrarian indicator. One of my favorite charts is a combination of sentiment and the return on the S&P 500 (Standard and Poor’s 500) index with a month lag, as shown in Figure 3.

Figure 3 shows that the stock market performs well in the following month during periods of negative sentiment. As mentioned, sentiment can turn quickly. So, sentiment (and other factors) may have changed when this article is published.


Using these four factors, you can form an opinion about asset allocation at different levels. At the first level, the two major asset classes, bonds and stocks, seem only slightly different based on these characteristics. In that case, a neutral weighting seems appropriate, with positive returns expected for both categories this year. In the longer run, the expected increase in bond volatility justifies an underweight for bonds versus equities. At the second level, in terms of regions, the US still seems like the place to be. In the somewhat longer term, valuations play a major role, and I see good opportunities for emerging markets. In terms of sectors, IT-like sectors seem perennially attractive. And last but not least, don’t forget the companies that will profit from the energy transition.



Bob Homan has been Chief Investment Officer at ING since 2008. He is responsible for the investment outlook and policy of ING Bank. His department analyses equities, bonds and mutual funds, handles portfolio management for Dutch clients and manages communications on financial markets.


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