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.