Rebalancing a Portfolio in a Volatile Market

As the share market gyrates around record highs, it is easy to conclude that risks are low. In fact, if a simple market truth is observed – that the higher the price you pay, the lower your return – then it must be true that as the market registers new highs, conditions are riskier.

For the past 37 years, global interest rates have been declining and Australia has not been immune. And since the global financial crisis, central banks have ensured that rate cutting has accelerated to zero, and in some cases, lower.

To understand where we are, it is important to be in possession of two frameworks: the first is how booms begin and turn into bubbles that burst; the second is to understand the maths of valuing assets.

In almost every case a boom begins on the foundation of a legitimate expectation for future growth. The current boom in technology is a case in point. It probably began with private equity billionaire Marc Andreessen’s article, ‘Why Software Is Eating the World’, in The Wall Street Journal in August 2011.

Andreessen made two observations. The first was,

“We believe that many of the prominent new Internet companies are building real, high-growth, high-margin, highly defensible businesses.”

The second was,

“Today’s stock market actually hates technology, as shown by all-time low price-earnings (PE) ratios for major public technology companies. Apple, for example, has a P/E of around 15.2, about the same as the broader stock market, despite Apple’s immense profitability and dominant market position.”

In 2011 there was a legitimate, and ultimately correct, expectation that software companies would generate significant revenue and profit from digitizing a vast range of industries and associated revenue models from logistics to advertising. It was also the case that many of these companies were out of favor. The tech crash of 2000 may have still been relatively fresh in investors’ minds.

Eventually, the thesis upon which the very smart money originally invested is embraced by a wider audience, and price momentum is generated, producing a boom.

Dumb follow the smart

But what the smart money does in the beginning, the dumb money does at the end. The boom morphs into a bubble when the original basis for investing is replaced by speculation that prices will continue in the future as they have in the recent past.

John Kenneth Galbraith in his 1955 book “The Great Crash, 1929” summarized a bubble best when he wrote:

“As noted, at some point in a boom all aspects of property ownership become irrelevant except the prospect for an early rise in price. Income from the property, or enjoyment of its use or even its long-run worth, is now academic. As in the case of the more repulsive Florida lots, these usufructs may be non-existent or even negative. What is important is that tomorrow or next week, market values will rise — as they did yesterday or last week — and a profit can be realized.”

As prices continue to rise, more speculators are lured in. When there are few if any participants remaining, who are willing to participate, something eventually emerges to pop the bubble.

When I wrote this piece, the US market fell 3 per cent overnight on the back of China devaluing its currency, and nobody was talking about a renminbi devaluation 48 hours ago.

The second framework to adopt involves an understanding of valuation theory.

The maths of valuing assets ensures that as interest rates decline, the present value of future cash flows rises. This is a fact often missed by investors. If receiving $10 in 10 years’ time is worth less than receiving the same $10 today, the difference is calculated using a discount rate also known as a required return. As interest rates fall, the required return falls and that future $10 is worth more today.

In essence, falling interest rates increase the “value” of assets because the present value of the future cash flows that asset produces is higher. And over time, prices follow values. This is because investors migrate away from lower-yielding cash towards assets that have the potential to produce higher yields.

Today, prices for all assets are at extreme levels. Excluding mining companies, the ASX 200 is trading at 18.7 times earnings, which is more than three standard deviations above the five-year average. The CAPE Shiller P/E Ratio for the S&P 500 has only been higher once since 1870. But stocks are not alone. Record prices are being achieved in almost all assets, from art to wine and collectible cars.

Earnings growth down

Meanwhile, as Australian share prices rise, underlining earnings are falling. The Australian market is expected to deliver just 1.9 per cent earnings growth in FY19, down from 4 per cent in FY18. Earnings growth and momentum, however, have been boosted by resources and material companies, with a growth of 15.6 per cent expected in FY19 following 27.2 per cent growth in FY18.

If resource companies are excluded from the list, analysts expect the remaining companies to produce a fall in earnings of 4.4 per cent.

In other words, thanks to unprecedented and accommodative monetary policy action, a disconnection has occurred between company earnings and their share prices, and the true risks are disguised by positive price momentum.

If low interest rates persist, there is a good argument to suggest asset prices will remain supported, if not elevated. But paying record prices for long-duration assets locks in a low return for a long period. And there is every possibility that rates will not remain low forever. There is also the possibility that something unexpected befalls investors, destabilizing the accepted wisdom enough to cause a reappraisal of risk.

One of the most common mistakes investors make when rates are declining is to chase yield. I saw this in early 2015 when Telstra shares were being chased up to more than $6.50.

I warned in The Australian in January 2015 that for investors chasing Telstra for its high dividend yield, the company was not going to be able to grow at a rate to justify that price. I also noted that the yield was unlikely to grow and I warned that the potential capital loss could be much greater than the extra yield being gained.

Growing yield important

Earning a higher yield offers immediate relief but there is a better solution. The key is not to buy the best-yielding investment but rather the asset whose yield will rise the most. A growing yield is superior to a fixed one, especially if inflation were to accelerate or even if it simply plods along where it is. Buy businesses that can grow their income, rather than those that are paying the highest yield today.

Another mistake investors make is to use the rear-view mirror as a guide to the future. If the past has been rosy the future may not necessarily be. But humans are terrible at predicting turning points and “black swans” always emerge to shatter the status quo. For this reason, it is important to adjust portfolio weightings dynamically through rebalancing.

Rebalancing a portfolio can be achieved in a number of ways and whichever method is chosen it recognizes that a set-and-forget approach may not be valid. Even large institutional investors rebalance their portfolios back towards an index to stay within tracking-error limits.

“Today, prices for all assets are at extreme levels”

Perhaps the most frequently cited rebalancing technique is based on scheduled periods such as quarterly or annually. Periodic rebalancing sets a regular interval for a portfolio’s weightings to be reviewed and adjusted.

It is entirely possible, of course, that a portfolio requires rebalancing before the scheduled date, and for that reason, some investors set ranges and boundaries for individual holdings, which, if exceeded, trigger a rebalancing.

For example, if it is undesirable for an allocation to tech stocks to exceed 15 per cent of a 10 per cent weighting in a portfolio, the investor would rebalance if that allocation rose above 11.5 per cent or fell below 8.5 per cent.

The proceeds of a rebalance of a security that has risen above the desired allocation can be reallocated to other securities or sectors that have declined, or they can be withdrawn from the portfolio by investors in the pension phase as a form of synthetic dividend without paying tax.

An alternative option, with its own set of risks, is to allocate the proceeds or a rebalance to cash to be used for new, as-yet-unidentified opportunities. Of course, at low rates of interest, cash creates a massive drag on performance.

However, if it is good enough for the world’s most successful investor, Warren Buffett, who is holding US$122 billion in cash or nearly 30 per cent of the book value of Berkshire Hathaway, it may be good enough for you.

There is a myriad of active portfolio management options available to investors to ensure risks are mitigated and these are especially useful when risks are disguised.

Roger Montgomery, Founder and Chief Investment Officer of Montgomery Investment Management