In Part I of this article, I showed the results of buy-and-hold versus intermittent rebalancing for 2008 and 2009, a period when we made horrible re-balancing decisions (and still came out ahead of buy-and-hold.) Now here are a couple actual examples of fair-to-middling good decisions…
If you look back to the inception of our model portfolios, 1999, our re-balancing discipline left us with:
· a 2% lesser return that year than the S&P (21.8% to 19.5%);
· in 2000, our re-balancing discipline left us with a 25% greater return than the S&P (minus 10.1% to our plus 15.6%);
· to 2001, a 20% larger return than the S&P (minus 13% to our plus 7.8%);
· to 2002, a 30% larger return than the S&P (minus 23.3% to our plus 7.8%).
Clearly, re-balancing to avoid at least some of the market’s downturns was a good thing to have done. In 2003, the market picked up and enjoyed a good run until 2007. Not a lot of need to re-balance when the fish are running your way. But during less-settled times? I believe intelligent re-balancing will beat buy- and-hold (as well as day-trading) in order to finish far ahead of the madding crowd.
Of course, markets can remain overvalued and climb even more, making re-balancers wish we had held on longer. Or they can become severely undervalued and make us wish we had waited another couple months before initiating positions. But we’re usually talking a couple to at most a few months. No honest analyst will tell you he or she can “time” the market. We don’t try. If, however, we can get to within a few weeks or months of a bottoming area by studying the geopolitical and economic environment, current events, PEs, yields, PSRs, book values, and investor sentiment, we’ve done what we set out to do.
Let me be clear: I am a long-term bull, and long-term bulls are often buy-and-hold types. I would like to be. But that would be the triumph of hope over experience. Still, 40 years of personal experience and a deep and close study of the previous nearly 200 years convince me that it is folly to bet against the long-term resiliency of the American economy and the American people.
Yes, we are sometimes (OK, often) led by idiots. (But we are the ones who elected them!) Yes, we sometimes shoot ourselves in the foot. But bet against the world’s most innovative people with the finest draw for citizens of every other nation to come here to work and live? That would be lunacy. So while we re-balance to lighten our exposure to US markets, we are never 100% in cash or 100% out of the US markets.
There are times when we are in only 10% in cash, but also only 10%-20% in US markets, with the rest in other developed and developing markets. But even in the worst of expected times, we do not have the arrogance to see the US economy, and therefore US markets, as down for the count.
I know many people believe “It’s different this time! Our troubles are far worse than ever before!” I heard the same thing when interest rates hit 21.5% (actually, the prime rate hit 21.5% -- other rates were higher) as a result of the terrible decisions made in the late 1970s. My parents heard the same thing during The Great Depression. I believe you will go broke shorting America. Americans bounce back.
As a result, we merely re-balance our model and client portfolios -- we do not panic about the demise of civilization as we know it. All the nay-sayers had their day in print but they neglected to count on the resiliency of the American people and the flexibility inherent in an economic system that rewards entrepreneurialism and innovation.
I happen to believe a short-term decline is the most likely immediate scenario. This is an unusual call because, typically, coming into a new year the markets are filled with hope and new money from year-end bonuses, raises, COLA increases for Social Security, and so on.
But this is a market that has come from 6,600 to 10,600 with hardly a pause along the way. Valuations have returned to levels that suggest a correction. Without taxpayer stimulus to buy cars and houses, auto sales and home sales are returning to recessionary levels. Portugal, Italy, Ireland, Greece and Spain are scaring investors with their possible inability to repay their debt. And investor sentiment is nervous as a cat on a hot stove.
I think it’s time to re-balance for protection. If I’m wrong, I don’t see it hurting us much -- I don’t see any catalyst on the horizon that might propel the markets from 10,400 up more than 7-10%, which would take us to 11,000 or so. I do see a number of scenarios, however, where a normal correction of 15-25% would result.
Missing 1,000 points on the upside would hurt our pride -- but we could easily recover from it merely by exceptional asset class, sector and/or stock selection. Losing 1,500 to 2,500 points on the downside, however, would be devastating to our wallets. Heck, losing the same 1,000 points on the downside would be scarifying, especially after the terror ride of 2008 and 2009. So if protection of capital means short-term under-performance, I see it as a good choice. Protecting capital is the step before increasing capital!
Please don’t mistake our brand of re-balancing with those who re-balance based on a particular technical timing signal or others who re-balance based upon a mechanical schedule : once a year, twice a year, four times a year, always on the same date. Those types of re-balancing will still often produce better returns than buy-and-hold, but they are too “mechanical” for us.
Ours is based, instead, upon our read of external events (sovereign nation debt fears, a collapse of the housing market, etc.), valuation (is the market cheap or dear based upon yield, prices relative to earnings, book value, sales, etc.), investor sentiment (are investors skittish or confident, ready to pounce on any concept or ready to sell based on this morning’s news, etc.) and what our experience in the market and proximity to its rhythms indicate to be the Right Thing to do right now. None are flawless. All taken together have allowed us to stay comfortably ahead of the benchmarks.
One final thought: I find, even in light of demonstrated superior performance, there remains one common roadblock to re-balancing: people confuse great companies with great stocks. There’s no question in my mind that Mr. Buffett’s favorite companies, like Coke, AmEx and Wells Fargo, are fabulous franchises. All have big moats around them, are difficult for new brands to steal market share from, are better-managed than most of their peers (no great feat for Wells in banking), attract good talent, and will continue to grow their earnings in future years. But so what?
If you fall in to the trap of thinking a great company means you should hold their stock through thick and thin, you have made such an amateurish mistake that you should not be surprised when your Citibank goes from 55 to 3 or your GE from 60 to 6 -- or your Coke, AmEx or Wells to single digits or low teens, for that matter.
Great companies are sometimes valued below where their long-term prospects would indicate they should be, and they are sometimes valued above where their long-term prospects would indicate they should be. You are not being “disloyal” or wishing the company that employed you for 30 years ill just because you sell their stock!
Try to think of stocks as what they are -- pieces of miniscule ownership that allow us to go along for the ride during periods where a particular company’s share price goes from undervalued to overvalued. The company raised its money in an IPO. They already have that money. Unless there is a secondary offering from the company, not merely insiders dumping into less-suspecting hands, your purchase is from a third party, either an institution or an individual. If you want to show fealty to the company, you’d do better to support them by buying one of their toothbrushes or razor blades or lawn tractors or whatever it is they sell. You aren’t buying from or supporting the company by holding their stock. Stocks are liquid securities that trade among individuals with different viewpoints as to their future prospects.
I am personally convinced that something like 40-50% of a securities’ appreciation is because the market itself is appreciating (hence we re-balance to stay in tune with the market), another 20-40% is based on how favorably that asset class and/or sector are viewed (hence our emphasis upon big sector themes) and only another 20% or occasionally a little more based on some exceptional factor with that company (hence intelligent stock selection as the final leg of our three-part approach). If you agree with this logic, then you cannot believe you should hold a particular stock through any and all market environments. Be flexible in recognizing that there are good markets and bad, good times to be a buyer and good times to be on the sidelines...
There will always be special situations in which to place a few dollars, even in a market that is correcting. Among those we have purchased for our model portfolios is the iPath S&P 500 VIX ETF (NYSEARCA:VXX), which is basically a play on the volatility of the market. Since most people will wait to sell until all others are selling, we’re betting that there will be a waterfall effect of selling and that volatility will rise -- and that VXX is a smart way to profit from their selling.
There’s a time to be fully invested -- and a time not to be. We believe a willingness to re-balance at important decision points will maximize your net worth and your peace of mind...
Author's Disclosure: We and / or clients for whom these investments are appropriate, are long VXX and a substantial cash cushion.
The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.
Also, past performance is no guarantee of future results, rather an obvious statement if you review the records of many alleged gurus, but important nonetheless – for example, our Investors Edge ® Growth and Value Portfolio beat the S&P 500 for 10 years running but did not do so for 2009. We plan to be back on track on 2010 but then, “past performance is no guarantee of future results”!
It should not be assumed that investing in any securities we are investing in will always be profitable. We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.