Monday, March 23, 2015

Time to Rebalance? How to Gauge the Risk to My Equity Exposure

This post is about whether and when I should consider rebalancing my financial assets portfolio away from equities. No graphs at present.

Gauging the Risk of a Bear Market
Most major market declines of the modern period have come after many if not all of the following things have occurred:
1. The market has reached new highs recently (highest in voer 6 years) Check!
2. Margin debt has reached new highs See: Check!
3. It has been more than 3 years since the last 18% decline in the market. Check!
4. Interest rates started rising more than 6 months ago. NO!
5. Actual or forecast corporate profits after tax and extraordinary items have fallen See: Maybe!
6. The market has experienced very strong 3 year growth rates Check! (and also 5 year growth rates!)
7. Market internals like the number of new highs each week or weekly advances minus declines number are falling.
8. Market capitalisation to GDP is at high levels near or above previous peaks. (Once said by Warren Buffet to be a measure he watches closely) Check for the US!
9. Robert Shiller's CAPE (Cyclically Adjusted Price Earnings) Ratio is at or near highs at which previous market reversals occurred. See: Check for the US!
10. The ratio of book value of assets to market value of the company (Q-Ratio) is at or near highs at which previous market reversals took place. Check for the US!
11. Governments are tightening fiscal policy substantially by reducing spending significantly.
12. Retail sales start falling for a few months, impacting on inventories, then production and employment. Not yet!
13 Volatility has been low for a few years. That tends to indicate complacency setting in after steady growth has been prolonged and looks like a "new normal". Check!
So I would argue that when many of these circumstances are in place is when the practical risk to your equity portfolio is likely to be getting relatively high.

But what if I miss out on a continuing bull market?
If the market is 100 and rises 20% it goes to 120. If it then falls 20% it goes back by 24 to 96. But if it falls 30% it goes back 84, which is the same as a 16% fall from 100. Most times if you miss the last 12 months of rises but invest after the market has fallen 20% you will be in front. After the initial falls of the 1929 Market crash is a glaring exception to that general statement.

But what about considering my personal circumstances before deciding?
There are a number of other factors beside the risk in the market to consider before making a decision:
1. The proportion of your financial assets to total assets. If they are only a small proportion it may not be as important to rebalance to avoid losses.
2. The proportion of your financial assets in the stock market. If you only have 50 or 60% in stocks and a couple of years living expenses in cash, and have a temperament to ride through a 20 to 30% fall in the stock market maybe you just rebalance back to say 60% every 3 to 6 months or  if you get to say 70% (or 50% when you get to 60% - whatever suits you personally)
3 Your dependency on your stock market assets for money to live.  If you barely have any buffer and you really have a very large proportion of total assets, excluding your home, in  the stock market, you might want to rebalance at least partially a bit early rather than a bit late.
4 Your volatility of temperament. Many private investors buy in late and sell out after a big fall because they are worried about a further loss. This becomes a very strong focus of your thoughts when you are 25% down, especially if it is on 90% of your financial assets and they are critical to funding your living expenses.

So which way am I leaning. 
As I am only about 60/40 in stocks I will wait for interest rates  to rise in the US or in my home country before rebalancing any further out of stocks. Over the last 25 years Australian rates have almost never been below US interest rates so US tightening is likely to be important when it eventually happens. Until US rates rise Australian rates are likely to fall because of the run off in the mining and resource related investment boom and the shuttering of the Australian car industry over 2015 to 2017. Unemployment is slowly increasing and job creation is below average.

The much discussed rise in US interst rates might be further away than people expect because of the recent significant increase in the USD compared to many currencies. That increases the "competitiveness" of imports can hurt US manufacturing and employment growth and make it harder to get wage rises and on the other hand the translation of foreign profits is less favourable under a higher USD

My conclusion for me.
So I wont rebalance away from stocks yet but your situation might be different.

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