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With the ASX200 up some 10% year-to-date and having achieved our 5900 year-end target within the first 6 weeks of the year, I felt it timely to commit some thoughts to paper.

Conversation between ourselves and investors is increasingly turning to the sustainability of the market’s recent rise. This is natural and entirely appropriate that we all continue to re-appraise our portfolio’s and their performance. In fact, I am thrilled with the level of engagement and awareness with where market’s now sit.

In the past two Friday update notes I have written, I have endeavoured to pre-empt this note and broader conversation by articulating how we felt. In short, we are cognizant of the rally and of fuller valuations across many of Australia’s blue-chip shares, but we are not overly concerned for markets. In fact, we think the ASX200 might likely push another 5% higher into the low 6000’s before it caps out. Even then, I’m not convinced it is pre-determined that the market must fall.

The issue isn’t necessarily whether we will be 5000 or 6000 at an index level, what is far more relevant to me is to ensure investors understand the likely ‘shape’ of market performance in the coming months. More precisely, what shares will do well and what won’t.

In a market where the index upside is becoming more limited, but otherwise well supported, it is paramount that we select stocks that are positioned to benefit from the prevailing economic environment. And that economic environment, both locally and globally is on the up.

In Australia, job advertisement figures are at over a 2-year high, service sector activity is at an 11-month high and consumer confidence continues to rebuild from the shock of the 2014 Federal Budget. Oil prices have collapsed, putting more money in consumer pockets. Interest rate falls to record lows do much the same, and the 20% fall in the Australian dollar means that for the first time in 5+ years, manufacturers are now reporting an increasing ability to produce domestically and not offshore. This is what we call green shoots, and this is precisely what is supposed to happen when stimulus occurs by way of currency, energy and interest-rate markets.

Globally, the US economy is going gangbusters. Manufacturing is into a 6-year uninterrupted recovery, any measure of consumer-confidence you use speaks to the best conditions since the GFC or beyond, and job openings are at a 14-year high. Things there are good, and so good in fact that after extraordinary monetary accommodation since 2008, the Federal Reserve are now in a position to raise interest rates. And this is a good thing.

In anticipation of tighter US interest rates, the US dollar has soared to a 12 year high. Again, the ramifications of a stronger dollar for global growth are positive. A stronger US dollar affords US consumers greater purchasing power globally. This is great news for exporters in places such as Asia and Europe, both regions that could use the demand. And so it continues. These are the knock-on positive effects we are now beginning to feel globally, and it is all pro-growth. I flagged it last week, but European retail sales volumes are now at their highest rate in 10-years, and why wouldn’t they be when so many countries in the Eurozone now have negative interest rates! Better to spend it on something of utility than allow it to waste in a bank account.

So, with the economic conditions changing, so too will the prevailing investment themes.

With this in mind it is my expectation that the focus of equity investors is set to shift from one on income, to one more reflective of improving economic growth.

Already in the past 6 months we have shifted our recommendations to reflect this dynamic. We have recently recommended Carsales.com (CAR), Crown Resorts (CWN), Adelaide Brighton Cement (ABC), Flight Centre (FLT) and even Computershare (CPU). All of these shares bear the hallmarks of leverage to an improving economy, and are non-sensitive to rising global bond yields.

So if growth is likely to improve, and globally bond yields look more at risk of rising, what happens to high-dividend paying shares that have been the market’s darling for much of the last 2 years?

Put simply, high-dividend yield stocks are increasingly LESS LIKELY to deliver capital appreciation. Valuations look expensive in several high-profile Australian banks, notably Commonwealth Bank (CBA) and Westpac (WBC). Telstra (TLS) who we have long been and continue to be a fan of, similarly is at the higher end of valuation ranges.

Given that these three shares comprise 25% of the ASX200 value, this fact is pertinent for the performance of the index but also for client portfolios.

If your portfolio is heavily overweight the banks and Telstra, and by this I mean, if your equity portfolio comprises 50% or more in banks and Telstra combined, you run the risk of underperformance.

It’s really important to ensure that your portfolio refreshes and is allowed to evolve into the changing economic environment. Where sitting idle and letting the banks and Telstra run this past few years has proven overwhelmingly successful, this has everything to do with the low interest-rate environment globally and the chase for income that has occurred as cash rates plummeted.

For now we are sticking with Telstra (TLS) as a defensive ‘income-proxy’, and we are broadly at benchmark weights in the major banks with a preference for National Australia Bank (NAB) still. However, in the rest of our managed portfolio’s we are keenly seeking to maximise our exposure to an improving economy. Who knows, but perhaps BHP (BHP) will turn up a fresh buy sometime soon since it is exposed to economic improvement and carries a yield in excess of both Commonwealth Bank (CBA) and Telstra (TLS)?

We would encourage you to follow us, and be vigilant to allow your portfolio to similarly evolve to reflect improving conditions.

Markets should be fine in the interim, but ensure that when stocks reach target levels be sure to rotate from one position to the next.