The traditional money management approach assumes that the stock market discounts the future economy--the stock market is the dependent variable and the economic outlook is the independent variable.
However, since the Great Recession, the opposite may have occurred. The Federal Reserve, with its quantitative easing, or its zero interest rate policy (ZIRP), has sought to inflate asset prices. Higher asset prices would result in a " wealth effect", which, the Fed believed, would stimulate consumption, and would kick start the economy into escape velocity, when the economy could resume growth at historical rates without ZIRP. In other words, the stock market would determine the economy, rather than vice versa.
The Federal Reserve has been successful in inflating assets. After all, the stock market, as measured by the Standard and Poor's 500 Index (the Index), has risen from 666 at the bottom in 2009 to over 2100 in six years. I have argued that the Index is now vastly overvalued.
However, the economy has so far failed to respond as expected. Growth has been sub-par since 2009. Only recently has the economy shown signs of a pickup in real growth. There has been talk of the Fed's soon raising the federal funds rate for the first time in many years. Unfortunately, events in China may thwart this virtuous cycle.
I have discussed that China is trying to morph from an export-driven economy into one relying more on internal consumption. That transition has proven to be difficult. The macroeconomic stats coming out of China have always been suspect, so it is difficult to know what reality is there. However, recent government measures to shore up the Chinese stock markets lead me to believe that economic growth there has slowed even more than recently expected.
The ramifications of a much slower growth in the Chinese economy are significant. For example, raw material prices, largely dependent on Chinese consumption, have dropped precipitously recently, resulting in severe drops in the currencies and stock markets of the raw material supplying countries.
If stock markets around the world continue to slide, then the key question is "Will the resultant NEGATIVE wealth effect cause a recession in the U.S.?" In other words, "Will the tail wag the dog?" If a recession occurs, then a bear market would surely ensue.
As you know, I have a very significant percentage of my financial assets in cash. My next decision is at what Index level would I increase my equity exposure? The answer is 1600. (The Index closed Friday at 1971, down from the bull market high of 2130.)
Why that price? 1) It represents a regression to the mean valuation of the Index over the last fifty years; 2) It is slightly above the bull market highs of 2000 and 2007, which now should be viewed as support levels; and 3) It is roughly a three-eighths retracement of the bull market from the 2009 low. That is an important Fibonacci number. Because many traders believe in such numbers, I pay attention to them.
Monday, August 24, 2015
Monday, March 23, 2015
TINA--The Greater Fool Theory In Disguise
As you who have been reading my posts know ad nausea, I believe that fair value for the stock market (the Standard and Poor's 500 Index) is the discounted cash flow of future dividends. The discount rate is a function of the ten-year U.S. Treasury note. I believe that both the stock and bond markets ultimately revert to historical norms. The key factors--discount rate, earnings, and earnings growth rate--each undergo this mean reversion.
Now, at 2108, the stock market is 67% overvalued according to Shiller's CAPE ratio. The latest argument to justify more upside is best described as TINA, an acronym for "There Is No Alternative!". After the yield to maturity of the ten-year Treasury bottomed below 1.5% in 2012, it has been bouncing around 2% for many months. Not much annual return over ten years. But if you plug a 2% discount rate into the stock market model, the fair value of the stock market is much higher than currently. So, given the assumption of a prolonged period of a much lower than normal 2% note yield, between stocks and bonds, there is presently no alternative but stocks--hence TINA.
However, once the Fed accomplishes its goal of raising the inflation rate to 2.0%, the ten-year yield should ultimately reach 4% to 5%--its norm. At that time, the stock market should approach fair value.
If mean reversion occurred immediately, the stock market would drop 40%; and the ten-year note 21%.
So if this happens soon, neither bonds nor stocks would be an alternative. However, there is a third alternative--CASH (or cash equivalents). I have been espousing building up a cash position by rebalancing the stock portfolio as the stock market becomes more overvalued. (I am awaiting a 70% overvaluation for my next rebalancing effort.) I have also suggested selling some long-duration bonds and either keeping the proceeds in cash or other short-duration assets.
Why does Wall Street tend to underplay CASH as an alternative?--1) I have mentioned before that Wall Street is bullishly biased. The industry makes much more money in a bull market than a bear. And most of the time, the stock market rises. If one makes a bullish bet and loses, he will not be alone; most of Wall Street will have also lost; so whatever accounts you lose, you will pick up accounts from others. However, if you are bearish and lose, it can be very lonely; and net money under management will likely diminish. 2) If most major asset management firms decided, say, to reduce their equity exposure by ten percentage points, that act in itself would precipitate a bear market--too many money managers exiting at once. 3) Most financial asset managers charge a percentage of assets as their compensation. If the client realizes that a portion of his assets is in cash, he might ask "Why am I paying you anything on the cash position?"4) High long-term capital gains tax rates, e.g., 31% in New York State, are a serious disincentive to selling equities in taxable accounts.
By ignoring cash as a viable asset class, those promoting TINA are engaged in "The Greater Fool Theory". That is, one fool believes he can buy an overpriced asset and sell it at a more overpriced level to a greater fool. Trading between stocks and bonds only is like trading one overpriced $10,000 dog for two overpriced $5,000 cats.
On another subject, I have placed our property of 21 years on the market at a "full" price, which represents a point of indifference between holding and selling. I have been lucky with this investment, as have most who bought real estate at reasonable prices more than two decades ago. As discussed in previous posts, pricing at this particular location has a very high Wall Street influence. So while my financial assets are only 30% in equities, if you adjust for this Wall Street factor, my real exposure to a bear market is significantly greater than if the property's value were not so correlated with how Wall Street fares. I dearly love the property, and the capital gains tax upon sale would be enormous. However, I long ago learned through a family experience never to fall in love with a material object! Given my view of the world, selling is the prudent thing to do.
Now, at 2108, the stock market is 67% overvalued according to Shiller's CAPE ratio. The latest argument to justify more upside is best described as TINA, an acronym for "There Is No Alternative!". After the yield to maturity of the ten-year Treasury bottomed below 1.5% in 2012, it has been bouncing around 2% for many months. Not much annual return over ten years. But if you plug a 2% discount rate into the stock market model, the fair value of the stock market is much higher than currently. So, given the assumption of a prolonged period of a much lower than normal 2% note yield, between stocks and bonds, there is presently no alternative but stocks--hence TINA.
However, once the Fed accomplishes its goal of raising the inflation rate to 2.0%, the ten-year yield should ultimately reach 4% to 5%--its norm. At that time, the stock market should approach fair value.
If mean reversion occurred immediately, the stock market would drop 40%; and the ten-year note 21%.
So if this happens soon, neither bonds nor stocks would be an alternative. However, there is a third alternative--CASH (or cash equivalents). I have been espousing building up a cash position by rebalancing the stock portfolio as the stock market becomes more overvalued. (I am awaiting a 70% overvaluation for my next rebalancing effort.) I have also suggested selling some long-duration bonds and either keeping the proceeds in cash or other short-duration assets.
Why does Wall Street tend to underplay CASH as an alternative?--1) I have mentioned before that Wall Street is bullishly biased. The industry makes much more money in a bull market than a bear. And most of the time, the stock market rises. If one makes a bullish bet and loses, he will not be alone; most of Wall Street will have also lost; so whatever accounts you lose, you will pick up accounts from others. However, if you are bearish and lose, it can be very lonely; and net money under management will likely diminish. 2) If most major asset management firms decided, say, to reduce their equity exposure by ten percentage points, that act in itself would precipitate a bear market--too many money managers exiting at once. 3) Most financial asset managers charge a percentage of assets as their compensation. If the client realizes that a portion of his assets is in cash, he might ask "Why am I paying you anything on the cash position?"4) High long-term capital gains tax rates, e.g., 31% in New York State, are a serious disincentive to selling equities in taxable accounts.
By ignoring cash as a viable asset class, those promoting TINA are engaged in "The Greater Fool Theory". That is, one fool believes he can buy an overpriced asset and sell it at a more overpriced level to a greater fool. Trading between stocks and bonds only is like trading one overpriced $10,000 dog for two overpriced $5,000 cats.
On another subject, I have placed our property of 21 years on the market at a "full" price, which represents a point of indifference between holding and selling. I have been lucky with this investment, as have most who bought real estate at reasonable prices more than two decades ago. As discussed in previous posts, pricing at this particular location has a very high Wall Street influence. So while my financial assets are only 30% in equities, if you adjust for this Wall Street factor, my real exposure to a bear market is significantly greater than if the property's value were not so correlated with how Wall Street fares. I dearly love the property, and the capital gains tax upon sale would be enormous. However, I long ago learned through a family experience never to fall in love with a material object! Given my view of the world, selling is the prudent thing to do.
Friday, September 19, 2014
Shiller CAPE Ratio Reaches 60% Overvalued--An Automatic Trigger to Rebalance Again
As discussed in previous posts, Professor Shiller's CAPE ratio has been, at best, a blunt market timing instrument. If one waited until his ratio dropped to fair value before buying, one would have missed the entire bull market from 2002 to 2007. However, as I mentioned in my last post, the CAPE ratio can be useful in determining when to rebalance. Rather than rebalance once a year, why not use the extent to which the market becomes overvalued as the trigger?
Today, the CAPE ratio reached 60% overvalued for the first time in this bull market which started in March 2009. For me, that is an automatic trigger to rebalance. Accordingly, I have sold 9% of my equity position to bring it back to its core level. The next trigger point would be if the CAPE ratio were to reach 70% overvalued.
Today, the CAPE ratio reached 60% overvalued for the first time in this bull market which started in March 2009. For me, that is an automatic trigger to rebalance. Accordingly, I have sold 9% of my equity position to bring it back to its core level. The next trigger point would be if the CAPE ratio were to reach 70% overvalued.
Thursday, July 10, 2014
Shiller's CAPE Versus the 10 year U.S. Treasury Note Yield--an Important Negative Correlation
The Federal Reserve has kept short-term interest rates at zero for more than five years. As a result, the yield on the U.S. Treasury 10 year note ("10 year note") dropped to a low under 1.50% in 2012. This initiative has been taken to avoid a depression -- to inflate the economy out of the great recession. The wealth effect from rising asset prices would kick start consumption. The economy would achieve escape velocity, at which point monetary easing could be withdrawn. We may be close to this inflection point.
I believe a dividend discount model to be the best way to determine the fair value for the Standard and Poor's 500 Index ("the stock market"). To me, fair value is the present value of the future dividend stream discounted to the present. The discount rate chosen for this calculation is vital. A higher discount rate implies a lower fair value; and vice versa.
The yield on the 10 year note is now "artificially" 2.60%. If one plugs a 2.60% discount rate into a dividend discount model, fair value would be much higher than the stock market's current price of 1972. Thus, the stock market would appear to be grossly undervalued. A well-known bond investor recently announced these low rates to be the "new normal". Thus, he suggests, this bull market has a long way to go on the upside. The phrase "new normal" reminds me of the most dangerous phrase in the Wall Street lexicon, "This time it's different!" With respect to what discount rate to use in a dividend discount model, I prefer the 10 year note yield averaged over a much longer period than five years.
Those of you who have been reading my posts know that I believe strongly in reversion to the mean. I seek to normalize earnings, earnings growth, and interest rates-- the most important variables determining fair value for the stock market when using a dividend discount model.
Professor Shiller at Yale has devised a method for normalizing earnings. For each of the last ten years, he adjusts each annual earnings for inflation, totals them, and divides by ten. Then by dividing the current price of the stock market by those earnings, he arrives at the market's adjusted price/earnings ratio. He calls it the CAPE ratio, an acronym for "Cyclically Adjusted Price Earnings" ratio. By dividing his current CAPE ratio by the historical average CAPE ratio, he arrives at the extent to which the market is overvalued or undervalued. (The CAPE numbers are available intraday by googling "Shiller's CAPE".)
With this methodology he eliminates the distortions arising from the profit margin cycle. I have argued that, all other things remaining constant, earnings above trend-line should have a lower than average price/earnings ratio, and vice versa. If one doesn't take the profit margin cycle into account, he is likely to buy high and sell low.
However, one major flaw in Shiller's CAPE ratio is that it fails to adjust fully for the level of interest rates. To test the effect of interest rates on CAPE, I have superimposed the chart of the 10 year note yield on the chart of CAPE over the last fifty years. (CAPE is in blue; Yield is in red.)
From 1964 to 1981, while the yield on the 10 year note rose from 4.2% to 15.2%, CAPE declined from 22.2 to 8.4. From 1981 to 2012, while the yield on the 10 year note declined from 15.2% to 1.5%, CAPE rose from 8.4 to 21.3. I conclude from this negative correlation over fifty years that interest rates have had a significant impact on p/e ratios.
Professor Shiller's data covers a 143 year period. My time interval is 50 years. Below are the various means over these two time periods.
CAPE 10 Year Note
Mean Mean
1871-2014 16.6 4.63%
1964-2014 19.6 6.64%
The CAPE ratio is currently 26.1, suggesting that the stock market is 57% overvalued based on the assumptions of a CAPE mean of 16.6 and the 10 year note mean of 4.63%. However, the current 10 year note yield, 2.60%, is more than 200 basis points below that of Shiller's interest rate mean. As long as interest rates remain so low, the bull market will continue. On the other hand, once inflation begins to rise and the Fed is forced to tighten, an upward move in rates to or beyond the 10 year note mean should result in CAPE's reverting to or below its mean. If that happens quickly, a bear market in stocks would occur.
Observations:
(1)The Fed, by keeping interest rates so low for so long, has heavily borrowed from future investment returns. A thirty year bull market in bonds probably ended in 2012. A secular bear market in bonds has probably begun. For those with very long horizons, such as Generation Xers, such a negative trend constitutes an enormous headwind for both bonds and stocks. The conventional asset allocations should be rethought. At the least, the duration of the fixed income portion should be significantly reduced. Some money should be taken out of stocks as well. The proceeds should be invested in non-correlating alternatives or kept in cash equivalents until mean reversions occur.
(2) For those of us who are retired with much shorter time horizons, the asset allocation decision becomes murky because it depends on how rapidly interest rates rise to the mean. If the adjustment is rapid, then both stocks and bonds would decline significantly. If a slow rise ensues, then the damage could be manageable. The problem is that we are in uncharted territory. Being risk averse, I would advise rebalancing the stock portfolio and placing the proceeds of stock sales into cash equivalents or very short duration treasury notes. The long duration bond portfolio should be eliminated, with the proceeds placed in shorter duration treasury notes. As I have said before, this strategy requires patience and discipline. It is not for everyone.
(3) If the economy stays in slow growth mode without any significant rise in inflation, then interest rates would remain low and the stock market could continue to appreciate. Hard to assign a probability to this occurrence.
(4) A slide into recession, a low probability at this point, would result in a serious downdraft in the stock market--probably as much as 30%. Bonds would appreciate in value even from these low interest rate levels.
On another subject, I intend to alter my rebalancing technique. Instead of rebalancing periodically, such as once a year, it makes more sense to rebalance according to overvaluation or undervaluation levels. That would mean that a melt up or melt down in the stock market could trigger rebalancing more frequently than once a year. I'm not predicting a melt up, but anything can happen.
Professor Shiller's data covers a 143 year period. My time interval is 50 years. Below are the various means over these two time periods.
CAPE 10 Year Note
Mean Mean
1871-2014 16.6 4.63%
1964-2014 19.6 6.64%
The CAPE ratio is currently 26.1, suggesting that the stock market is 57% overvalued based on the assumptions of a CAPE mean of 16.6 and the 10 year note mean of 4.63%. However, the current 10 year note yield, 2.60%, is more than 200 basis points below that of Shiller's interest rate mean. As long as interest rates remain so low, the bull market will continue. On the other hand, once inflation begins to rise and the Fed is forced to tighten, an upward move in rates to or beyond the 10 year note mean should result in CAPE's reverting to or below its mean. If that happens quickly, a bear market in stocks would occur.
Observations:
(1)The Fed, by keeping interest rates so low for so long, has heavily borrowed from future investment returns. A thirty year bull market in bonds probably ended in 2012. A secular bear market in bonds has probably begun. For those with very long horizons, such as Generation Xers, such a negative trend constitutes an enormous headwind for both bonds and stocks. The conventional asset allocations should be rethought. At the least, the duration of the fixed income portion should be significantly reduced. Some money should be taken out of stocks as well. The proceeds should be invested in non-correlating alternatives or kept in cash equivalents until mean reversions occur.
(2) For those of us who are retired with much shorter time horizons, the asset allocation decision becomes murky because it depends on how rapidly interest rates rise to the mean. If the adjustment is rapid, then both stocks and bonds would decline significantly. If a slow rise ensues, then the damage could be manageable. The problem is that we are in uncharted territory. Being risk averse, I would advise rebalancing the stock portfolio and placing the proceeds of stock sales into cash equivalents or very short duration treasury notes. The long duration bond portfolio should be eliminated, with the proceeds placed in shorter duration treasury notes. As I have said before, this strategy requires patience and discipline. It is not for everyone.
(3) If the economy stays in slow growth mode without any significant rise in inflation, then interest rates would remain low and the stock market could continue to appreciate. Hard to assign a probability to this occurrence.
(4) A slide into recession, a low probability at this point, would result in a serious downdraft in the stock market--probably as much as 30%. Bonds would appreciate in value even from these low interest rate levels.
On another subject, I intend to alter my rebalancing technique. Instead of rebalancing periodically, such as once a year, it makes more sense to rebalance according to overvaluation or undervaluation levels. That would mean that a melt up or melt down in the stock market could trigger rebalancing more frequently than once a year. I'm not predicting a melt up, but anything can happen.
s
Friday, June 27, 2014
The Importance of Rebalancing--a Fair Test
The American Association of Individual Investors ("AAII"), with its several hundred thousand members, can have an important influence on the behavior of individual investors. Its May 2014 journal contained an article entitled "The Danger of Getting Out of Stocks During Bear Markets." The author compares, over a 25 year period, three investment strategies, all of which start with 70% in stock funds and 30% in bond funds: 1) selling completely out of stocks after a 20% market decline and reinvesting a year later ("panicking"); 2) holding the stock portfolio throughout ("not rebalancing"); and 3) rebalancing the asset allocation annually ("rebalancing"). The annualized returns were pre-tax. There were no assumed annual withdrawals. Risk is defined as the standard deviation of returns.
Unfortunately, the author chose an interval of time for his study--end of 1988 to end of 2013-- which is biased in favor of not rebalancing. At the end of 1988, the Standard and Poor's 500 Index ("the market") was at fair value. (I use Professor Shiller's CAPE Index for valuation purposes.) At the end of 2013, the market was 50% overvalued. With such an increase in overvaluation during the test period one might expect the strategy of not rebalancing to be preferable to rebalancing.
A fair test would be over a time interval that starts and ends at the same relative valuation level. The market was 50% overvalued at the end of 1995. So I ran a test beginning at the end of 1995 and ending at the end of 2013 using the author's own Excel spreadsheets. The results over the two disparate time periods are shown below.
1988-2013 1995-2013
Return Risk Return Risk
Panicking 7.8% 12.6% 4.9% 11.8%
Not Rebalancing 9.7% 14.2% 8.1% 14.2%
Rebalancing 9.6% 12.6% 8.4% 13.1%
Observations:
1) Both test time horizons demonstrate the problem with panicking. Relative to panicking, rebalancing during the 1988-2013 period resulted in a 23% greater return with equal risk. During the 1995-2013 period, rebalancing generated a 71% greater return with only 11% more risk than occurred with panicking--clearly a preferable risk/reward pairing.
Unfortunately, many individual investors buy high and sell low. Flows into and out of equity mutual funds over time confirm this activity. Panicking epitomizes this behavior. On the other hand, rebalancing involves selling high and buying low or vice versa.
2) During the fair test period, 1995-2013, rebalancing generated 4% more return with 8% less risk compared with not rebalancing--thus, rebalancing is the better strategy over this time period!
In his article, the author of the AAII study deconstructed rebalancing as merely a diversionary tactic--discouraging the individual investor from panicking during a bear market. These results above show that rebalancing accomplishes much more.
3) Even during the author's chosen test period, which I deem biased, the wisdom of not rebalancing instead of rebalancing is debatable. It really depends on one's risk orientation. Being risk averse, I prefer rebalancing. After all, to increase one's risk by 13% to achieve a mere 1% greater return isn't attractive to me. For some, however, it might be.
Where Are We Now?
Right now, Shiller's work shows the market to be 56% overvalued. Being a believer in the concept of reversion to fair value, I am interested in how these three strategies would fare during a period that started with the market 50% overvalued and ended with the market at fair value. Such a period occurred from the end of 1995 to the end of 2008. The figures below show the results of this test.
1995-2008
Return Risk
Panicking 2.6% 12.6%
Not Rebalancing 5.0% 14.9%
Rebalancing 5.8% 13.9%
Observations:
1) Rebalancing is by far the best strategy among these three. In comparison with panicking it generates 123% more return with only 10% more risk. Relative to not rebalancing it returns 16% more with 7% less risk.
2) The annualized return from the best of these strategies is a mere 5.8%. That compares favorably with the recent 2.6% yield on the 10 year U.S. Treasury Note and is why the stock market continues to rise despite its being 56% overvalued. However, were inflation to reach the Fed's 2%+ objective, and the 10 year note yield rapidly to revert to its norm of 300 basis points above inflation, then a prospective 5.8% return for equities would be deemed inadequate compared with a 5% yield on the 10 year note. A bear market would likely ensue.
These observations argue for rebalancing now if one hasn't already done so.
Table 1. Performance of the Three Strategies 1988-2013
Strategy 1: Panicking: Annualized return 7.8% Risk 12.6%
Strategy 2: Not Rebalancing: Annualized return 9.7% Risk 14.2%
Strategy 3: Rebalancing: Annualized return 9.6% Risk 12.6%
Note that panicking generates only 81% of the annualized return from rebalancing with the same risk. Therefore, rebalancing is, by far, the better strategy. From an initial $100,000 invested, panicking ends with a portfolio valued at $702,179; rebalancing with $1,087,803. Many individual investors buy high and sell low. Flows into and out of equity mutual funds confirm this activity. Panicking epitomizes this behavior--not a good strategy. On the other hand, rebalancing involves selling high and buying low. Moral of this story--Don't Panic!
According to this test's results, the wisdom of rebalancing versus rebalancing is debatable. It really depends on one's risk orientation. I, for one, prefer rebalancing. After all, to increase one's risk by 12% to achieve a 1% greater return isn't attractive to me. For some, it might be.
The author deconstructs rebalancing as merely a diversionary tactic -- discouraging the investor from panicking in a bear market. It does accomplish that, but much more as well. Unfortunately, the author chose an interval for his study that is biased in favor of holding the stock portfolio throughout without rebalancing (Strategy 2). At the end of 1988, when the study began, the stock market, as measured by the Standard and Poor's 500 Index, was at fair value. (I use Shiller's CAPE Index for valuation levels.) At the end of 2013, it was 50% overvalued. With that kind of increase in valuation, one might expect not rebalancing to win out over rebalancing. A fair test would be a time interval that starts and ends at the same valuation level. Using Shiller's work, the market was 50% overvalued at the end of 1995. Following are the results for the 18 years from the end of 1995 through 2013 using AAII's Excel spreadsheets.
Table 2. Performance of the Three Strategies 1995-2013
Strategy 1: Panicking: Annualized return 4.9% Risk 11.8%
Strategy 2: Not Rebalancing: Annualized return 8.1% Risk 14.2%
Strategy 3: Rebalancing: Annualized return 8.4% Risk 13.1%
The results of this fair test proclaim rebalancing, Strategy 3, to be clearly superior to not rebalancing, Strategy 2, because the return of Strategy 3 is 4% higher and the risk 7% lower. And Strategy 3, again, is far better than Strategy 1.
The final table shows the results when the period starts with 50% overvaluation, the end of 1995, and ends at fair valuation, the end of 2008.
Table 3. Performance of the Three Strategies 1995-2008
Strategy 1: Panicking: Annualized return 2.6% Risk 12.6%
Strategy 2: Not Rebalancing: Annualized return 5.0% Risk 14.9%
Strategy 3: Rebalancing: Annualized return 5.8% Risk 13.9%
As expected, during a period starting with overvaluation and ending with fair valuation, rebalancing easily trumps not rebalancing. Annualized return for the former exceeds that of the latter by 16% and the risk is 7% lower.
Where Are We Now?
The methodology behind Shiller's CAPE Index valuation model is intended to dampen the distorting effect of the profit margin cycle by taking the average earnings over the last ten years rather than earnings during the last twelve months. Since I believe in the concept of regression to the mean, this approach is appealing to me.
Shiller's CAPE Index is available for a nominal fee. While it is not useful for market timing over a short interval of time; it is useful for periods greater than seven years--very important in retirement planning for those with decades to go before reaching retirement age. It is also useful for selecting test intervals.
Right now, Shiller's work shows the S&P 500 Index to be 56% overvalued. Given the test results above, rebalancing would be appropriate at this time.
I
Unfortunately, the author chose an interval of time for his study--end of 1988 to end of 2013-- which is biased in favor of not rebalancing. At the end of 1988, the Standard and Poor's 500 Index ("the market") was at fair value. (I use Professor Shiller's CAPE Index for valuation purposes.) At the end of 2013, the market was 50% overvalued. With such an increase in overvaluation during the test period one might expect the strategy of not rebalancing to be preferable to rebalancing.
A fair test would be over a time interval that starts and ends at the same relative valuation level. The market was 50% overvalued at the end of 1995. So I ran a test beginning at the end of 1995 and ending at the end of 2013 using the author's own Excel spreadsheets. The results over the two disparate time periods are shown below.
1988-2013 1995-2013
Return Risk Return Risk
Panicking 7.8% 12.6% 4.9% 11.8%
Not Rebalancing 9.7% 14.2% 8.1% 14.2%
Rebalancing 9.6% 12.6% 8.4% 13.1%
Observations:
1) Both test time horizons demonstrate the problem with panicking. Relative to panicking, rebalancing during the 1988-2013 period resulted in a 23% greater return with equal risk. During the 1995-2013 period, rebalancing generated a 71% greater return with only 11% more risk than occurred with panicking--clearly a preferable risk/reward pairing.
Unfortunately, many individual investors buy high and sell low. Flows into and out of equity mutual funds over time confirm this activity. Panicking epitomizes this behavior. On the other hand, rebalancing involves selling high and buying low or vice versa.
2) During the fair test period, 1995-2013, rebalancing generated 4% more return with 8% less risk compared with not rebalancing--thus, rebalancing is the better strategy over this time period!
In his article, the author of the AAII study deconstructed rebalancing as merely a diversionary tactic--discouraging the individual investor from panicking during a bear market. These results above show that rebalancing accomplishes much more.
3) Even during the author's chosen test period, which I deem biased, the wisdom of not rebalancing instead of rebalancing is debatable. It really depends on one's risk orientation. Being risk averse, I prefer rebalancing. After all, to increase one's risk by 13% to achieve a mere 1% greater return isn't attractive to me. For some, however, it might be.
Where Are We Now?
Right now, Shiller's work shows the market to be 56% overvalued. Being a believer in the concept of reversion to fair value, I am interested in how these three strategies would fare during a period that started with the market 50% overvalued and ended with the market at fair value. Such a period occurred from the end of 1995 to the end of 2008. The figures below show the results of this test.
1995-2008
Return Risk
Panicking 2.6% 12.6%
Not Rebalancing 5.0% 14.9%
Rebalancing 5.8% 13.9%
Observations:
1) Rebalancing is by far the best strategy among these three. In comparison with panicking it generates 123% more return with only 10% more risk. Relative to not rebalancing it returns 16% more with 7% less risk.
2) The annualized return from the best of these strategies is a mere 5.8%. That compares favorably with the recent 2.6% yield on the 10 year U.S. Treasury Note and is why the stock market continues to rise despite its being 56% overvalued. However, were inflation to reach the Fed's 2%+ objective, and the 10 year note yield rapidly to revert to its norm of 300 basis points above inflation, then a prospective 5.8% return for equities would be deemed inadequate compared with a 5% yield on the 10 year note. A bear market would likely ensue.
These observations argue for rebalancing now if one hasn't already done so.
Table 1. Performance of the Three Strategies 1988-2013
Strategy 1: Panicking: Annualized return 7.8% Risk 12.6%
Strategy 2: Not Rebalancing: Annualized return 9.7% Risk 14.2%
Strategy 3: Rebalancing: Annualized return 9.6% Risk 12.6%
Note that panicking generates only 81% of the annualized return from rebalancing with the same risk. Therefore, rebalancing is, by far, the better strategy. From an initial $100,000 invested, panicking ends with a portfolio valued at $702,179; rebalancing with $1,087,803. Many individual investors buy high and sell low. Flows into and out of equity mutual funds confirm this activity. Panicking epitomizes this behavior--not a good strategy. On the other hand, rebalancing involves selling high and buying low. Moral of this story--Don't Panic!
According to this test's results, the wisdom of rebalancing versus rebalancing is debatable. It really depends on one's risk orientation. I, for one, prefer rebalancing. After all, to increase one's risk by 12% to achieve a 1% greater return isn't attractive to me. For some, it might be.
The author deconstructs rebalancing as merely a diversionary tactic -- discouraging the investor from panicking in a bear market. It does accomplish that, but much more as well. Unfortunately, the author chose an interval for his study that is biased in favor of holding the stock portfolio throughout without rebalancing (Strategy 2). At the end of 1988, when the study began, the stock market, as measured by the Standard and Poor's 500 Index, was at fair value. (I use Shiller's CAPE Index for valuation levels.) At the end of 2013, it was 50% overvalued. With that kind of increase in valuation, one might expect not rebalancing to win out over rebalancing. A fair test would be a time interval that starts and ends at the same valuation level. Using Shiller's work, the market was 50% overvalued at the end of 1995. Following are the results for the 18 years from the end of 1995 through 2013 using AAII's Excel spreadsheets.
Table 2. Performance of the Three Strategies 1995-2013
Strategy 1: Panicking: Annualized return 4.9% Risk 11.8%
Strategy 2: Not Rebalancing: Annualized return 8.1% Risk 14.2%
Strategy 3: Rebalancing: Annualized return 8.4% Risk 13.1%
The results of this fair test proclaim rebalancing, Strategy 3, to be clearly superior to not rebalancing, Strategy 2, because the return of Strategy 3 is 4% higher and the risk 7% lower. And Strategy 3, again, is far better than Strategy 1.
The final table shows the results when the period starts with 50% overvaluation, the end of 1995, and ends at fair valuation, the end of 2008.
Table 3. Performance of the Three Strategies 1995-2008
Strategy 1: Panicking: Annualized return 2.6% Risk 12.6%
Strategy 2: Not Rebalancing: Annualized return 5.0% Risk 14.9%
Strategy 3: Rebalancing: Annualized return 5.8% Risk 13.9%
As expected, during a period starting with overvaluation and ending with fair valuation, rebalancing easily trumps not rebalancing. Annualized return for the former exceeds that of the latter by 16% and the risk is 7% lower.
Where Are We Now?
The methodology behind Shiller's CAPE Index valuation model is intended to dampen the distorting effect of the profit margin cycle by taking the average earnings over the last ten years rather than earnings during the last twelve months. Since I believe in the concept of regression to the mean, this approach is appealing to me.
Shiller's CAPE Index is available for a nominal fee. While it is not useful for market timing over a short interval of time; it is useful for periods greater than seven years--very important in retirement planning for those with decades to go before reaching retirement age. It is also useful for selecting test intervals.
Right now, Shiller's work shows the S&P 500 Index to be 56% overvalued. Given the test results above, rebalancing would be appropriate at this time.
I
Thursday, December 26, 2013
"History doesn't repeat itself, but it does rhyme."--Mark Twain
Mark Twain's wonderful comment resonates on Wall Street. We who attempt to predict the future course of equity prices are always searching for the perfect indicator. That indicator would embody the concept of "all and only." That is, ALL sought after outcomes are preceded by the indicator and ONLY sought after outcomes are preceded by it. In other words, there are no false negatives and no false positives. Alas, there are no perfect indicators, only those that "rhyme."
Those who have read my previous posts know that I am a contrarian investor. I tend to sell when there is an extreme of bullishness and buy when there is an extreme of bearishness. During my career, I have found the most reliable sentiment indicator to be the Investors Intelligence Sentiment Index Survey published by Investors Intelligence ("II").
For fifty years the people at II have scrutinized weekly more than a hundred independent financial market newsletters and categorized each writer's outlook for the stock market into three groups--bullish, bearish, and expecting a correction. Each category's percentage of the total is published. Rarely do these weekly numbers have predictive value -- they're just noise. At extreme levels, however, they do have significance. Since we are in a bull market and want to know when to cut back our risk exposure to equities, we should be looking for an extreme high percentage of bulls and an extreme low percentage of bears. To me, the combination of 60% or more bulls and 20% or less bears defines "extreme".
During the last 25 years, there have been only five previous occasions when this extreme occurred. The percentage change in the Standard and Poor's 500 Index ("the Index") one year afterward (excluding dividends) was plus 4.3% from January 22, 1992, plus 12.4 % from June 18, 2003, plus 5.9% from February 25, 2004, plus 3.4% from December 29, 2004, and MINUS 39.0% from October 17, 2007. Overall, the average change was MINUS 2.6%, which is much lower than the 6% to 7% average annual appreciation (excluding dividends) during this period.
Another way of describing these results is that there were four false positives, of which three were of minor significance, and one, plus 12.4%, a glaring error. Overall the predictive value was good because this indicator nailed the bull market peak in 2007. A cynic might grouse that "this sentiment indicator has forecast five of the last one bear market." I should also mention that there was one glaring false negative. This indicator failed to detect the bull market top in March 27, 2000, from which the Index fell 25.3% in one year!
This reminds me of an incident that occurred during a tour to China. Every time our group left our bus, we were besieged by vendors. Once, a fellow traveller boarded our bus with an ear-to-ear grin. She exclaimed with glee, "I just bought a Gucci bag for a dollar!" As she walked by me, I noticed that the brand name on the bag was spelled "G-u-c-c-e". When I called that to her attention, she responded without missing a beat, "CLOSE ENOUGH!"
While this sentiment indicator is far from perfect, it is "close enough." The latest reading is 59.6 % bulls, 14.1% bears. While not quite my threshold point of 60% or more bulls and 20% or fewer bears, it is unique over the last 25 years. I back-tested how often more than 59% bulls and fewer than 15% bears has occurred during that lengthy time period. NEVER!! Furthermore, the last time there were only 14.1% bears was in March, 1987! I have brought my equity risk exposure down from 42% of my financial assets to my core level of 30%.
A reminder: for reasons I have explained in earlier posts, I have determined that a core equity holding of 30% is appropriate for me, given my other asset holdings and age. Among investment advisors, the standard core holding for equities has been roughly 60%, with around 40% in bonds, and little, if any, cash. With bond returns negative during 2013 and the Index up 30%, the stock/ bond relationship is seriously out of whack. If unadjusted, the stock portion of the portfolio has grown to 67% of financial assets.
Following this great equity surge, you might say "Let me get this straight! After such a year, you are asking me to sell my equities down to my core of 60% and put the money in cash equivalents, returning nothing? The Fed is tapering, so they think the economy has achieved escape velocity. Earnings are growing. Things couldn't get much better! Are you crazy?" Here's why I recommend lightening up.
The Current Situation
Let's look at the three most important forward-looking variables: sentiment, the Federal Reserve's future action, and valuation.
Sentiment
As noted above, sentiment has reached a level of extreme bullishness. That doesn't happen UNLESS things are great.
Federal Reserve
On December 18, the Federal Reserve announced its initial tapering. They softened the announcement by saying that they intend to keep their Federal Funds rate at zero for a long time. While the Fed has far more input on how the economy is faring than I, their forecasting record has been far from stellar. If the expectation of future inflation picks up and the long end of the bond market experiences a ratcheting up in yields, then the Fed may be forced to raise the Fed Funds rate. In other words, the Fed will be "behind the curve". This has happened often in the past and has given rise to the phrase "bond vigilantes." No matter how the Fed has couched its action last week, it is still a tightening.
The Fed's target for inflation is 2% or slightly more. While the nominal yield on the U.S. Treasury 10 year note is currently 2.9%, the real yield, adjusted for the current 1.1% inflation, is closer to 1.8%. For many years, the real yield on that security averaged 3 percentage points. Add that to the Fed's inflation target of 2.0 %, one would expect that the yield on the 10 year note would ultimately reach 5%+. How long that will take is crucial! For purposes of discussion, let's assume the absurd case that the yield adjusts immediately. Then, in my opinion, the result of the yield's breaking convincingly through 3.0% would mean a 10% correction in the Index; through 4%, a 20% bear market; and through 5.0% as much as a 30% decline. However, this will be spread over time. The longer it takes, the less downward impact on the Index, because the effect will be mitigated by annual normalized earnings growth of 6% to 7%.
Valuation
At 1833 the Index is 40% overvalued. At the peak of the bull market that ended in March, 2000, the Index was 100% overvalued; at the peak of the next bull market in October, 2007, the Index was 80% overvalued. So there could be a lot further room to run, particularly since individual investors seem to adjust their equity exposure while looking in the rear view mirror. As bond yields rise and investors continue to lose money, the inclination is to sell bonds and buy stocks. That rotation may only be in the early innings. However, if bond yields rise quickly, the institutional investor, at some level, will sell overvalued stocks to take advantage of good yields. This downward pressure on the Index will cause the individual investor to halt his rotation into stocks.
If the last bull market's peak 80% overvaluation were to repeat, then there is 30% more upside in this bull market. My rebalancing now will have, in hindsight, been a mistake. However, I will still have my core equity position working on the upside.
Those who have read my previous posts know that I am a contrarian investor. I tend to sell when there is an extreme of bullishness and buy when there is an extreme of bearishness. During my career, I have found the most reliable sentiment indicator to be the Investors Intelligence Sentiment Index Survey published by Investors Intelligence ("II").
For fifty years the people at II have scrutinized weekly more than a hundred independent financial market newsletters and categorized each writer's outlook for the stock market into three groups--bullish, bearish, and expecting a correction. Each category's percentage of the total is published. Rarely do these weekly numbers have predictive value -- they're just noise. At extreme levels, however, they do have significance. Since we are in a bull market and want to know when to cut back our risk exposure to equities, we should be looking for an extreme high percentage of bulls and an extreme low percentage of bears. To me, the combination of 60% or more bulls and 20% or less bears defines "extreme".
During the last 25 years, there have been only five previous occasions when this extreme occurred. The percentage change in the Standard and Poor's 500 Index ("the Index") one year afterward (excluding dividends) was plus 4.3% from January 22, 1992, plus 12.4 % from June 18, 2003, plus 5.9% from February 25, 2004, plus 3.4% from December 29, 2004, and MINUS 39.0% from October 17, 2007. Overall, the average change was MINUS 2.6%, which is much lower than the 6% to 7% average annual appreciation (excluding dividends) during this period.
Another way of describing these results is that there were four false positives, of which three were of minor significance, and one, plus 12.4%, a glaring error. Overall the predictive value was good because this indicator nailed the bull market peak in 2007. A cynic might grouse that "this sentiment indicator has forecast five of the last one bear market." I should also mention that there was one glaring false negative. This indicator failed to detect the bull market top in March 27, 2000, from which the Index fell 25.3% in one year!
This reminds me of an incident that occurred during a tour to China. Every time our group left our bus, we were besieged by vendors. Once, a fellow traveller boarded our bus with an ear-to-ear grin. She exclaimed with glee, "I just bought a Gucci bag for a dollar!" As she walked by me, I noticed that the brand name on the bag was spelled "G-u-c-c-e". When I called that to her attention, she responded without missing a beat, "CLOSE ENOUGH!"
While this sentiment indicator is far from perfect, it is "close enough." The latest reading is 59.6 % bulls, 14.1% bears. While not quite my threshold point of 60% or more bulls and 20% or fewer bears, it is unique over the last 25 years. I back-tested how often more than 59% bulls and fewer than 15% bears has occurred during that lengthy time period. NEVER!! Furthermore, the last time there were only 14.1% bears was in March, 1987! I have brought my equity risk exposure down from 42% of my financial assets to my core level of 30%.
A reminder: for reasons I have explained in earlier posts, I have determined that a core equity holding of 30% is appropriate for me, given my other asset holdings and age. Among investment advisors, the standard core holding for equities has been roughly 60%, with around 40% in bonds, and little, if any, cash. With bond returns negative during 2013 and the Index up 30%, the stock/ bond relationship is seriously out of whack. If unadjusted, the stock portion of the portfolio has grown to 67% of financial assets.
Following this great equity surge, you might say "Let me get this straight! After such a year, you are asking me to sell my equities down to my core of 60% and put the money in cash equivalents, returning nothing? The Fed is tapering, so they think the economy has achieved escape velocity. Earnings are growing. Things couldn't get much better! Are you crazy?" Here's why I recommend lightening up.
The Current Situation
Let's look at the three most important forward-looking variables: sentiment, the Federal Reserve's future action, and valuation.
Sentiment
As noted above, sentiment has reached a level of extreme bullishness. That doesn't happen UNLESS things are great.
Federal Reserve
On December 18, the Federal Reserve announced its initial tapering. They softened the announcement by saying that they intend to keep their Federal Funds rate at zero for a long time. While the Fed has far more input on how the economy is faring than I, their forecasting record has been far from stellar. If the expectation of future inflation picks up and the long end of the bond market experiences a ratcheting up in yields, then the Fed may be forced to raise the Fed Funds rate. In other words, the Fed will be "behind the curve". This has happened often in the past and has given rise to the phrase "bond vigilantes." No matter how the Fed has couched its action last week, it is still a tightening.
The Fed's target for inflation is 2% or slightly more. While the nominal yield on the U.S. Treasury 10 year note is currently 2.9%, the real yield, adjusted for the current 1.1% inflation, is closer to 1.8%. For many years, the real yield on that security averaged 3 percentage points. Add that to the Fed's inflation target of 2.0 %, one would expect that the yield on the 10 year note would ultimately reach 5%+. How long that will take is crucial! For purposes of discussion, let's assume the absurd case that the yield adjusts immediately. Then, in my opinion, the result of the yield's breaking convincingly through 3.0% would mean a 10% correction in the Index; through 4%, a 20% bear market; and through 5.0% as much as a 30% decline. However, this will be spread over time. The longer it takes, the less downward impact on the Index, because the effect will be mitigated by annual normalized earnings growth of 6% to 7%.
Valuation
At 1833 the Index is 40% overvalued. At the peak of the bull market that ended in March, 2000, the Index was 100% overvalued; at the peak of the next bull market in October, 2007, the Index was 80% overvalued. So there could be a lot further room to run, particularly since individual investors seem to adjust their equity exposure while looking in the rear view mirror. As bond yields rise and investors continue to lose money, the inclination is to sell bonds and buy stocks. That rotation may only be in the early innings. However, if bond yields rise quickly, the institutional investor, at some level, will sell overvalued stocks to take advantage of good yields. This downward pressure on the Index will cause the individual investor to halt his rotation into stocks.
If the last bull market's peak 80% overvaluation were to repeat, then there is 30% more upside in this bull market. My rebalancing now will have, in hindsight, been a mistake. However, I will still have my core equity position working on the upside.
Friday, November 1, 2013
Rebalance Now?
I have taken no action in my account since my last post in March, 2013. Due to equity appreciation and some reduction in cash to pay living expenses, equity mutual funds are now 40% of my total financial assets, with the remaining 60% in cash equivalents. My core, or target, equity position is roughly 30%. Should I rebalance now by reducing equity mutual funds by 25%?
Argument For Rebalancing (1)
Based on my assumptions of 1) normalized earnings of roughly 87 for the S&P 500 Index; 2) a normalized P/E ratio of 15; and 3) a normalized 5% yield to maturity for the U.S. Treasury 10 year note, fair value for the Index is 1300. The Index is currently selling at 1760; thus, based on these metrics, it is 35% overvalued.
Counterargument
Fair value, though relevant, is a blunt instrument. In 2000, at the top, according to this model, the S&P 500 was 100% overvalued. So there is further upside to go.
Furthermore, this model of theoretical fair value assumes a 5% yield on the ten year Treasury note. That note is now yielding 2.6%. If you inserted a 2.6% yield into this model, the Index is vastly undervalued.
Argument For Rebalancing (2)
During more than two centuries of U.S. history, economic cycles have occurred roughly once every four to five years. This up cycle has already lasted more than four years from the last trough, and close to six years from the last peak. Thus, based on history, it is long in the tooth.
Also, five years from the trough in the 1930s Depression, there was an "echo" recession in 1938. This last recession was the worst since that Depression. Perhaps there is an echo recession in the near future.
Counterargument
There is symmetry in economic cycles. That is, short, shallow recessions lead to short, shallow recoveries. The last recession was called "The Great Recession" for good reason; it was both long and deep. So the recovery will be longer than usual, and may have years to go.
Also, Fed Chairman Bernanke, a scholar of The Depression, has been vigilant in keeping monetary policy extremely easy; and his replacement, Janet Yellen, is considered even more of a "dove." While there is a possibility of monetary policy's being ineffective in preventing another recession ("pushing on a string"), remember the Wall Street admonition, "Don't fight the Fed!" The Fed will continue its monthly purchases of $85 billion of long-dated Treasuries and mortgages until there are clear signs of the economy's achieving escape velocity.
Argument For Rebalancing (3)
When the economy achieves escape velocity, and the Fed starts to reduce its $85 billion of monthly purchases, or what is now known as "tapering", interest rates at the long end of the yield curve will rise sharply due to this withdrawal of demand. This will stifle the housing recovery, cause the stock market to drop precipitously, and essentially end the positive wealth effect that has been the backbone of the paltry economic recovery during the last four years.
Counterargument
Taken alone, rising interest rates should have a negative effect on stock prices. However, there will be an offset. Due to more rapid real economic growth and inflation, earnings growth will pick up, so while the P/E ratio will be lower, earnings will be higher.
Argument For Rebalancing (4)
Between the end of World War II and 2000, real economic growth in the U.S. averaged 3.5% a year; and that included recession years. Since 2000, real average economic growth has been below that, bringing the post -War average economic growth down to 3.2%. Since the bottom of the Great Recession, economic growth has been a meager 2% and inflation under 2%. With top line revenue growth of around 4%, how can American companies generate a 7% earnings growth in the future, particularly with profit margins at all time highs?
Counterargument
The multinational companies based in America are investing in more rapidly growing areas of the world, such as Southeast Asia. That has had a meaningful effect on overall top line growth.
Furthermore, many of these companies are engaging in financial engineering. They are sitting on large amounts of nonessential cash. These companies are buying back their stock in quantities that exceed the amount needed for stock options. This has had the impact recently of raising annualized earnings per share by 1 1/2 to 2 percentage points. Unfortunately, companies tend to buy back their shares when their stocks are overvalued. Better that they reserve the cash when things are going well, and repurchase the shares when their stock is undervalued. How much this repurchasing will impact future earnings per share is tough to predict. Excess cash may not be replenished, so there will be a finite life to this.
Given these pros and cons, how do I come out on this?
Some key issues:
1) Tapering will inevitably take place. When and how rapidly is important. And even more important is how rapidly and to what extent long-term interest rates rise as a result. The bond market, like the stock market, anticipates the future. Once tapering begins, then future increases in the federal funds rate, now at close to zero percent, appear on the radar screen. An increase in the yield of the Treasury 10 year note from 2.6% to 3.0% would cause some downside in the stock market, perhaps 10 percent. A rapid increase to 4.0% would, in my opinion, result in a bear stock market (down 20%) because bonds would then become competitive with stocks and mortgage rates would rise to a level that may choke off the housing recovery.
2) An unlikely event, but if an "echo" recession cannot be prevented by the Fed, then the S&P 500 Index could easily drop 30%. And that decline could happen very fast. (See October, 1987, when the market was down more than 20% in one day.)
3) Most important in my view of reality, the sentiment indicator that I watch most carefully is not yet at the extreme in bullishness that I would consider a red flag. Most, but not all, bull markets end when greed becomes extreme. (Again, October, 1987 was a rare exception.)
4) Money invested in the bond market is in the process of being transferred into equities due to the fact that bonds have already lost money recently even before tapering has begun. This trend should
continue for awhile.
While I may regret this suspension of discipline, I have chosen not to rebalance at this time. If the sentiment indicator flashes red, I shall immediately rebalance and perhaps take my equity risk exposure below my core level.
Argument For Rebalancing (1)
Based on my assumptions of 1) normalized earnings of roughly 87 for the S&P 500 Index; 2) a normalized P/E ratio of 15; and 3) a normalized 5% yield to maturity for the U.S. Treasury 10 year note, fair value for the Index is 1300. The Index is currently selling at 1760; thus, based on these metrics, it is 35% overvalued.
Counterargument
Fair value, though relevant, is a blunt instrument. In 2000, at the top, according to this model, the S&P 500 was 100% overvalued. So there is further upside to go.
Furthermore, this model of theoretical fair value assumes a 5% yield on the ten year Treasury note. That note is now yielding 2.6%. If you inserted a 2.6% yield into this model, the Index is vastly undervalued.
Argument For Rebalancing (2)
During more than two centuries of U.S. history, economic cycles have occurred roughly once every four to five years. This up cycle has already lasted more than four years from the last trough, and close to six years from the last peak. Thus, based on history, it is long in the tooth.
Also, five years from the trough in the 1930s Depression, there was an "echo" recession in 1938. This last recession was the worst since that Depression. Perhaps there is an echo recession in the near future.
Counterargument
There is symmetry in economic cycles. That is, short, shallow recessions lead to short, shallow recoveries. The last recession was called "The Great Recession" for good reason; it was both long and deep. So the recovery will be longer than usual, and may have years to go.
Also, Fed Chairman Bernanke, a scholar of The Depression, has been vigilant in keeping monetary policy extremely easy; and his replacement, Janet Yellen, is considered even more of a "dove." While there is a possibility of monetary policy's being ineffective in preventing another recession ("pushing on a string"), remember the Wall Street admonition, "Don't fight the Fed!" The Fed will continue its monthly purchases of $85 billion of long-dated Treasuries and mortgages until there are clear signs of the economy's achieving escape velocity.
Argument For Rebalancing (3)
When the economy achieves escape velocity, and the Fed starts to reduce its $85 billion of monthly purchases, or what is now known as "tapering", interest rates at the long end of the yield curve will rise sharply due to this withdrawal of demand. This will stifle the housing recovery, cause the stock market to drop precipitously, and essentially end the positive wealth effect that has been the backbone of the paltry economic recovery during the last four years.
Counterargument
Taken alone, rising interest rates should have a negative effect on stock prices. However, there will be an offset. Due to more rapid real economic growth and inflation, earnings growth will pick up, so while the P/E ratio will be lower, earnings will be higher.
Argument For Rebalancing (4)
Between the end of World War II and 2000, real economic growth in the U.S. averaged 3.5% a year; and that included recession years. Since 2000, real average economic growth has been below that, bringing the post -War average economic growth down to 3.2%. Since the bottom of the Great Recession, economic growth has been a meager 2% and inflation under 2%. With top line revenue growth of around 4%, how can American companies generate a 7% earnings growth in the future, particularly with profit margins at all time highs?
Counterargument
The multinational companies based in America are investing in more rapidly growing areas of the world, such as Southeast Asia. That has had a meaningful effect on overall top line growth.
Furthermore, many of these companies are engaging in financial engineering. They are sitting on large amounts of nonessential cash. These companies are buying back their stock in quantities that exceed the amount needed for stock options. This has had the impact recently of raising annualized earnings per share by 1 1/2 to 2 percentage points. Unfortunately, companies tend to buy back their shares when their stocks are overvalued. Better that they reserve the cash when things are going well, and repurchase the shares when their stock is undervalued. How much this repurchasing will impact future earnings per share is tough to predict. Excess cash may not be replenished, so there will be a finite life to this.
Given these pros and cons, how do I come out on this?
Some key issues:
1) Tapering will inevitably take place. When and how rapidly is important. And even more important is how rapidly and to what extent long-term interest rates rise as a result. The bond market, like the stock market, anticipates the future. Once tapering begins, then future increases in the federal funds rate, now at close to zero percent, appear on the radar screen. An increase in the yield of the Treasury 10 year note from 2.6% to 3.0% would cause some downside in the stock market, perhaps 10 percent. A rapid increase to 4.0% would, in my opinion, result in a bear stock market (down 20%) because bonds would then become competitive with stocks and mortgage rates would rise to a level that may choke off the housing recovery.
2) An unlikely event, but if an "echo" recession cannot be prevented by the Fed, then the S&P 500 Index could easily drop 30%. And that decline could happen very fast. (See October, 1987, when the market was down more than 20% in one day.)
3) Most important in my view of reality, the sentiment indicator that I watch most carefully is not yet at the extreme in bullishness that I would consider a red flag. Most, but not all, bull markets end when greed becomes extreme. (Again, October, 1987 was a rare exception.)
4) Money invested in the bond market is in the process of being transferred into equities due to the fact that bonds have already lost money recently even before tapering has begun. This trend should
continue for awhile.
While I may regret this suspension of discipline, I have chosen not to rebalance at this time. If the sentiment indicator flashes red, I shall immediately rebalance and perhaps take my equity risk exposure below my core level.
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