Asset Allocation, as our clients and readers know, refers to the diversification of an investment portfolio among a variety of liquid asset classes. At Park Piedmont (PPA), we use four such asset classes: Cash Equivalents; High Credit Quality Bonds; High Yield/Lower Credit Quality Income; and Stocks.
In times of modest market price changes, allocations that have been established to meet clients’ long-term financial and related goals, with acceptable levels of risk, can generally be left relatively unchanged. We typically consider updates if and when (A) client goals change substantially; and/or (B) market prices adjust so significantly that the portfolio percentage allocation among the four asset classes no longer represents an acceptable level of risk and reward. With this in mind, we think a discussion of recent increasing stock prices may be useful.
Using the S&P 500 index as a proxy for the US stock market, that index ended June 30, 2021, up 95% from its March 2020 low (at a time when the severity of Covid-19 became clear). The March 2020 low was 33% below the previous high reached in January of 2020. These are significant price movements in short time frames, occasioned at least in part by an unexpected event, the coronavirus pandemic. The almost incredible stock price recovery since March 2020, attributed at least in part to continuing very low interest rates and a recovering US economy as the negative impacts of the virus waned, may well create the impression of an ever-rising stock market. But this recent history should not necessarily be a reason to keep adding money to your stock portfolio.
First, these increasing stock prices may well have anticipated an economic recovery, in which case prices might already have reached their peaks, as reflected by high historic valuations (P/E ratios).
More importantly from an asset allocation perspective, high stock prices suggest the possibility of rebalancing your portfolio, which would involve reducing the stock percentage, thereby returning to the previously established allocation made in less volatile times. Such re-balancing can be accomplished either by selling stocks and buying the other asset classes (i.e., cash, bonds, or high-yield income, assuming no need to use any of the sale proceeds) or using additional cash to buy the non-stock asset classes. Selling, or at least reducing the allocation of, the asset class whose prices are rising may seem counterintuitive. But the rationale is that the higher prices get, the more extended valuations are to support stock prices, which makes some significant price reduction more likely at some point. Note this is not market timing, which involves trying to determine/predict in advance of the event when prices will rise or fall. Instead, re-balancing involves a quantitative basis for at least revisiting the portfolio allocation percentages to see if you’re comfortable retaining the higher risk asset or prefer to make some reduction to lower the portfolio risk (even in a taxable account, which is exposed to capital gains taxes).
For those interested in rebalancing, the big question becomes what to do with the proceeds from the stock sales, in a time when bonds face the threat of inflation, rising interest rates, and declining prices.
A recent NY Times article by Jeff Sommer, entitled “Higher Inflation Ahead, Don’t Try to Predict It,” (7/4/21, page B3) focuses on the difficulty even experts have in predicting the future, especially complex financial events such as the return of inflation, its timing, and its impact. Sommer also provides the following advice and information pertinent to the asset allocation discussion: “If you happen to be lucky enough to have some money to invest, relax. You do not need a crystal ball. Embrace a buy and hold strategy, setting up a portfolio with diverse, low-cost index funds, including stocks and bonds, in an appropriate asset allocation…. Add stocks to the mix if you want to take on more risk. Add bonds, preferably Treasuries, if you want more safety. It’s true that if inflation surges, bond prices could be expected to fall, but not by much. The stock market can lose more in a week than the bond market loses in a bad year.”
The article provides historical figures from Vanguard covering 1926 through 2020. A 100% stock portfolio returned an average annual 10.2% (including dividends) over that 94-year period, with declines in 25 of those years and a worst-year decline of 43%. A 100% bond portfolio returned an average annual 6%, with 19 years of declines and a worst-year decline of 8.1%. (PPA note: with interest rates still so low, earning 6% on a bond portfolio currently would not be possible, but the notion that stock prices can be much more volatile than bonds continues to be so). The article concludes that “In any case, there’s little point in worrying, because we don’t know where we’re heading. Uncertainty is part of life. We all deal with it every day. It’s when people act as if they can predict the future that they scare me.”
Another relevant article, “Wishful Thinking in a World Without Yield” by Jason Zweig (6/18/21, WSJ online), focuses on using bonds as part of your asset allocation. Zweig observes that “the challenge we all face as investors is that the collapse in interest rates makes achieving historical rates of return very difficult…. When cash and bonds yield close to zero, stacking the traditional assets on top of that isn’t enough…. But you can’t earn a higher return from alternative assets just because you need to.” The article posits three basic choices: (1) increase existing holdings of risky assets like stocks, even though no one thinks they are cheap; (2) add new and exotic bets and hope they do not blow up; and (3) grit your teeth and stay the course, through a period of what may be lackluster returns, until interest rates finally normalize. Zweig concludes that “People are looking for the silver bullet/magic wand….but there isn’t one.” (Emphasis added.)
A third article, by Neil Irwin in the NY Times (7/9/21, page B1), reviews the last few months (end of March through June 8th) of bond price changes. Irwin notes that bond prices have actually gone up as interest rates have gone down (1.75% to 1.30% for the 10-year Treasury), even with all the media attention on an expanding economy and the potential for additional inflation.
At PPA, we recognize that bond prices are vulnerable to higher interest rates. But the same higher interest rates that cause price declines also provide additional interest income, which typically offset the lower prices over time. The amount of time depends a great deal on how fast rates rise in the marketplace. Bonds also serve as a buffer to the much more extreme risk of large stock price declines, such as the period from late 2007 to spring 2009, when the S&P 500 declined by 65% while bond returns were positive. The largest annual bond price decline, by comparison, was approximately 8%. Because bond prices don’t fluctuate as much as stock prices, bonds are useful when money needs to be withdrawn from portfolios. It’s preferable not to have to sell stock when those prices might have declined significantly. Indeed, rebalancing suggests buying stocks when their prices are lower, again with the objective of returning the portfolio to its predetermined asset mix established in more normal times.
Everyone wants to be in stocks when they are rising, as now, and out when they are declining. This market timing is difficult for anyone, in or out of the investment business, to accomplish. The core concept of asset allocation is to avoid market timing by maintaining an appropriate allocation to meet your long-term financial goals within your risk tolerance.
As Larry Swedlow tells us each month, do not confuse likelihoods (e.g., stocks recover from declines, and stocks outperform bonds) with certainty. The consequences of going from rich to poor should dominate your allocation decisions. If you have already accumulated substantial amounts of money, with no real need to take on additional portfolio risk, this should provide a rationale for not adding to stocks, and maybe even rebalancing out of some stocks.
As for predicting the future direction of the financial markets, as usual, only time will tell. Our longstanding advice continues: maintain the asset allocation designed for your specific long-term goals, and try to ignore advice to make portfolio changes in an effort to time the market’s unpredictable future moves.