To Rebalance Or Not To Rebalance? --That Is The Question

Most every investor who operates only from the long side has suffered significant losses on the equity portion of his or her financial assets during this bear market. At some point, to preserve one's chosen equity-to-total financial assets relationship, one should rebalance the portfolio. In down markets, that would mean adding to equities and, in up markets, selling some equities. A vicious bear market "makes cowards of us all." Investors are balking at adding to equities. However, unless one has strong conviction that we are beginning a deflationary spiral (what the economists call a "deflatonary adverse feedback loop"), rebalancing during a bear market can enhance long-term performance AS LONG AS THE SECULAR TREND OF EQUITIES IS UP.

Those of you who have read my previous postings know that I am betting that enough of the government's spaghetti thrown at the wall will stick to avoid a depression. It might be beneficial to give an example of rebalancing. In mid-October last year when I reached my 40% equity allocation, or "all in", the S&P 500 Equity Index stood at roughly 840. Unfortunately, I had purchased half the position at a higher price, so that my average cost was at an S&P 500 price of 1080. To simplify this example, I am not including dividends on equities or interest on fixed income investments (90 day Treasury bills in my case). Let's assume there was $100 of total financial assets when the S&P was at 1080, with $60 in fixed income and $40 in equities. Let's also assume that I rebalance now when the S&P is at 700. The original $40 equity position would now be $25.92 and the original fixed income portion still at $60, for total financial assets of $85.92. To rebalance, one would have to bring the equity position up to $34.37, which is 40% of $85.92. That would mean a 33% addition, or $8.45, to the current equity position ($25.92).

At what S&P 500 level should one rebalance? This is an especially difficult decision right now. I still believe that the market is in a bottoming process and that October 10 was a breadth and volume climax. However, the recession continues to deepen. S&P 500 operating earnings for the 2008 fourth quarter were negligible now that AIG has reported. Tangible book value for the S&P 500 is difficult to trust because no one knows whether there is any "book value" left in many financials. I have been using normalized earnings, around $64, as one metric. Another has been the trendline connecting the bottoms of 1974 and 1982, which currently is in the 600-650 area.

Here is another one which I discovered reading the Financial Times yesterday. In his column, John Authers said that "US stocks have shown a strong trend for more than a century, growing by 6.75% per year after inflation, with income reinvested." He then refers to a study by London's Lombard Street Research that points out that there have been only 26 months during the last 140 years (1,680 months) when the S&P 500 was further below this trend than it is now. All of these 26 months except six, three each in 1932 and 1982, occurred during world wars.

Since this recession is probably going to be worse than in the early '80s, let's forget about 1982 and look at what happened in 1932. According to this study, "stocks fell another 25% more after becoming this cheap compared with trend--but then doubled in a matter of weeks." If this phenomenon were to repeat, the S&P 500 would drop to 522 and then double to 1044 in a matter of weeks.

Trying to synthesize all of this into action is difficult. My opinion is to rebalance at roughtly 600 in the S&P 500.