Capturing Opportunities Through Science

In early March, Balentine increased exposure to Emerging Market equities and eliminated exposure to gold bullion in order to increase the expected upside capture of our Market Risk building block.

Progress in the European debt crisis and better US economic data over the last three months have led to significantly less market volatility. As risks to the near-term outlook have abated, momentum in global equity markets has accelerated. Based on the long-term attribution of our returns, such an environment typically provides a compelling backdrop for us to harness the power of our quantitative models (the “Science” component of our “Art and Science” approach), because during such “normal” market environments, underlying asset class performance trends persist for longer. Over the last two years we have exposed portfolios to as much “Art” as our portfolio construction rules would allow – a good decision given the volatile environment that unfolded.  However, due to the normalization of market environments, we believe now is a good time to take profits in some “Art” areas to fund the opportunities our “Science” models are signaling.

While our models in general still lean towards emphasizing domestic exposure within Market Risk, they have warmed to certain international equity markets. Compared to both large and small-cap domestic equities, Emerging Market equities are less expensive than they used to be due to a period of severe underperformance in 2011. In the last few months, momentum has picked up, and it has accelerated over the last month.  Though Emerging Market equities are vulnerable to a European banking crisis, the Long Term Repo Operations (LTRO) the European Central Bank first undertook last December have significantly reduced this risk.  The LTRO has provided abundant liquidity and a back-stop to the banking system while politicians continue wrangling about the long-term structural reforms that are necessary to underpin the Euro. In early March, the combination of these factors led us to establish direct exposure to an asset class with one of the highest expected long-term returns in our 2012 Capital Market Forecasts.

In order to fund the allocation to Emerging Market equities, we eliminated exposure to gold bullion. We first established exposure to this Art-based theme in 2010, and when we published “Gold: Dr. Pangloss or Chicken Little?” in May 2011, gold had reached a 50 year high at $1,535 an ounce.  Gold continued its historic rise, reaching a price of nearly $1,900 late last year.  On average, it maintained a price of above $1,500 an ounce in 2011, as investors rewarded its hedging abilities against uncertainty in general and in particular, the continued debasement of paper currencies in the developed world, as we mentioned earlier this year.

Although the long-term indicators we monitor to exit gold bullion remain intact (negative real interest rates, positive fund flows from central banks and a slow steady devaluation of US dollar persist), over the near- to medium-term, gold looks overbought. The Federal Reserve has also acknowledged the positive developments in the US economy, making additional rounds of quantitative easing in the near future less likely. If recovery falters and Central Banks resort to further rounds of printing money, we may well allocate to this Art based theme again in the future. But for now, we judge that the combination of emerging market bonds, stocks and commodities – all good hedges against the debasement of fiat currency in the developed world – are sufficient to protect against the current stance of  monetary policy in the US, Europe, UK and Japan.

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