Time to Rebalance

Golden Retriever Balancing

The time to Rebalance Portfolios has come,

....but has it gone?

The market correction commencing on February 5, 2018 was a wake-up call and generated more than a few phone calls. But it should actually have added value to financial advisors and their clients. Yes, it could alarm some, especially after such a long run of low volatility. But it should also serve to enhance portfolio values and build wealth

How Does a Correction Add Value?

Two Ways a Correction Helps Investors:
  1. A correction creates a market entry point for new money. Many investors and advisors have been reticent about placing new trades lately due to the long running bull market. The reasoning seems to be that the odds of the bull market ending or a major draw down are higher than the obverse. Some of this was calculated patience, waiting for a correction to present better value opportunities. Some of it was fear of sustaining gains or concern that equities had become over-priced. Another issue has been lack of confidence in sustained economic growth.
  2. Corrections create an opportunity to rebalance portfolios. Harvesting gains to deploy in undervalued holdings that have declined in market value, is the principle underlying rebalancing. Provided that the holdings’ decreased market price truly results in undervaluation and not for a good reason, such as diminished future cash flow potential.

A properly constructed portfolio is comprised of holdings that provide an optimal balance of risk and return. Over time, a well-diversified portfolio will get out of balance, almost by definition.  

Diversification means that the portfolio has low correlation among its constituent holdings and between the overall portfolio and the holdings. That low correlation means some will gain value over time and some won’t, or they will gain differentially. Since we can’t know the future, diversification is the best method of mitigating uncertainty. That is to say, diversification is about having a foot in multiple future scenarios.

Among the worst investing mistakes is failing to acquire an undervalued asset. That is the essence of value investing articulated by Ben Graham in his classic The Intelligent Investor. Avoiding this mistake requires knowing the fair or intrinsic value of a holding. That value is the discounted sum of future cash flows, to the investor. Easier said than done, but the successful investor will have a view derived from careful research and the courage of conviction to take action on that view.

Worse yet is to let a gain get away by not taking some of it off the table. Even if it triggers a capital gains tax, it is better to lock in 85% of a gain than to lose it all. In fact a long term capital gains tax event is, in reality, good news. Money has been made!

But the absolute worst mistake is not being informed or prepared. Rebalancing is not an annual work flow that can be put on the calendar. It is rather event driven, and needs to be planned well in advance with monitoring systems in place, alerts set up and action items in place. Above all, it needs to be executed timely to capture the most value.

Monitoring the economy and markets generally is a good start. But maintaining a current view of intrinsic value for both holdings and those on the “buy list” is the real essence of value investing. But again, the courage to act decisively is the critical ingredient. Watching the market go by and remorsefully seeing opportunity go away is a regrettable but all too frequent consequence of lacking a consistent investment process well executed.

So what can we say about the February correction? More importantly, what opportunities were presented? More important still, what are the opportunities still available? Ultimately, how can we be prepared for the future, taking advantage of renewed market volatility? For investors this means growing wealth, for advisors it means better serving their clients.

S&P 500 Investment Opportunities

The S&P 500 has become richly valued as measured by its Price/Earnings (P/E) ratio. Rising from its month end low of 12.5 in September 2011 to 24.0 in January, the market valuation nearly doubled. Even so, the valuation was well below 2 Standard Deviations (SD) above the 20 year mean. Two SDs above the mean is considered the bubble threshold, while two SDs below is the bust barrier. That is, outside this range equities are nearly certain to fall or rise back toward the mean. This is even more likely for a broad index such as the S&P 500. What is not so certain is how fast and to what level. Generally reversions to the mean is the expectation, but reversion can under or over shoot the mean and may occur quickly or over the course of weeks, months and even years.

The S&P 500 Index market price breached its 12 month trend line on December 28, rising from 11,336 to a point just shy of 12,000 on January 31, 2018. That was clearly not sustainable and became the first signal that a correction was likely if not imminent. It turned out that it was imminent, crashing through the 50 day moving average on February 3 and falling to the 200 day moving average on February 8. It quickly recovered to the 12 month trend line on February 15 and has oscillated around it since, albeit with much higher volatility through the close on Friday March 16.

Thus, there continue to be buying opportunities and the greatest opportunity to harvest gains came in late January-early February. Not that I advocate market timing, that is just what the numbers show. There continue to be opportunities, but it appears that volatility has subsided, perhaps limiting gains or buying opportunities.

But wait there’s more! (Sorry, I could not resist.)

S&P Sector Investing

The 11 component sectors of the S&P 500 Index exhibit some different, interesting and potentially lucrative opportunities. Remembering those low correlations, several sectors present serious buy signals while others flash harvest signs.

Highlights of Investing Opportunities

Consumer Discretionary revealed one of the most significant harvest opportunities. This index powered through the +2SD Price barrier on January 22 and though it dropped precipitously in early February, it bottomed out at the 12 month trend line and has since rebounded above the +2SD threshold. 

Despite this amazing price run-up, the index is still well below its 20 year +1SD valuation (P/E) level. The moving averages suggest the trend may be flattening out. Forward estimates of earnings indicate valuation may be reverting closer to the mean. This is an example of earnings growth supporting higher valuation, clearly a positive development.

In contrast, the Consumer Staples Index blew through the 12 month trend line on November 29 and reached a new 52 week high on January 26 of 1057, 49 points above the previous high in June. It then went into free fall dropping to 963 on February 8, rebounded to near the trend line, but has oscillated in a downward path since.

The Price/Earnings trend has been similar, but less dramatic. The P/E ratio has reverted to just above the 10 year mean. Forward estimates of earnings are sufficiently strong that the current market price should be easily supported and in fact has a reasonable likelihood of rebounding significantly. These two reinforcing patterns suggest Consumer Staples is an attractive buying opportunity.

Financial Sector is expected to have a bright future due to deregulation and rising interest rates. As such, the market price of the index reached a new 52 week high of 822 on January 26 yet fell below the 12 month trend line on February 5 reaching its low point of 739 on February 8. Recovery above trend has been sustained since.

The Price/Earnings trend reinforces optimism about the Financial Sector. The high point of 17.5 times trailing twelve months earnings before the correction is only +1SD above the 20 year mean and retrenchment puts it below 17 as of the close on March 16. Forward estimates of earnings indicate the P/E will be slightly below the mean through the end of the fiscal year. Despite or perhaps because of increased volatility, the financial sector is fertile ground for wealth building.

Health Care Sector has strong fundamentals supported by the demographic trend of aging baby boomers. With this as a backdrop, the S&P 500 Health Care Index has had one of the most dramatic rises of the last 12 months. From 1175 at the end of January 2017 to 1566 on January 26, 2018 the index experienced a 33% increase. The fall was also fairly dramatic, dropping through the trend line, 50 day and 200 day moving averages within a few days. Recovery has been rather anemic oscillating below trend. The 50 day moving average is converging on the 200 day, suggesting near term price weakness.

The P/E trend indicates the index is slightly over valued but not dramatically, well below +1SD. Forward earnings estimates indicate support for the P/E at this level and perhaps some improvement through the end of the fiscal year. The Health Care sector appears to provide an attractive investment or rebalancing opportunity.

Information Technology (IT) is perhaps more closely associated with boom and bust cycles than any other S&P sector. The fall from grace in the early years of the 21st century is still fresh in the minds of investors and advisors when the P/E fell from 50 to near 25 over the course of two years. That represented a reversion from well over +2SDs to right about the 20 year mean. Following a rebound to over 40 the IT sector had been in decline until January of 2014, rising gradually from -1SD to cross the mean in October 2017 and rocket up to nearly +1SD by late January.

On a 52 week market value view, the IT sector followed a more volatile but nonetheless steady rise until its price peaked on January 26, 2018. It then fell below the 12 month trend line, the 50 day moving average and rebounded off the 200 day average back to the trend line which it has tracked since, rising slightly above it during March.

The P/E ratio should be well supported if forward earnings estimates are realistic. There is even a possibility of even greater price appreciation.

IT along with the other sectors we have highlighted seems to offer good investment opportunities for rebalancing into these sectors. Consumer Discretionary is one source of gains to be harvested for re-deployment.

Monitoring the indices, from both a Price/Earnings and Market Value perspective can provide advisors and investors with the signals that a rebalancing event is approaching. But a rebalancing plan needs to be in place so that opportunity can be seized in a timely fashion. Once the signals start to flash, action items are already in place, ready for execution.

As we all know, markets move fast.border colly 712398 1920

The key components of sound rebalancing
  1. A well-constructed portfolio based on post-Modern Portfolio Theory asset allocation.
  2. Best in class holdings representing the chosen asset classes
  3. A watch list of potential holdings that would augment the portfolio as economic and market conditions change.
  4. Regular economic and capital market updates focused on the evolving business cycle.
  5. A monitoring system that tracks market values (Daily Prices) and valuation metrics (P/E ratios). Trading tools can also be helpful in determining market entry/exit points.
  6. A plan with buy and sell thresholds, decision points, authorizations and trade execution action items.

Having all of these in place will enhance the opportunities, allow for timely and efficient execution.

Note: If you would like a briefing on the analysis underlying this post please send us an email with your request.