What is an investor to do when stock markets roar to record highs in 2019, and the vision for 2020 is anything but 20/20?
Buying into the rally or selling to lock in gains are options, but instead of guessing where markets are heading the most prudent move to kick off the new decade might be a portfolio rebalance.
In 2019 the S&P 500 rose in value by 30 per cent, continuing a 10-year bull market that has seen the stock market benchmark soar nearly 400 per cent. Even sluggish commodity prices couldn’t keep the Canadian benchmark S&P/TSX 60 Index from posting a 23-per-cent return.
Outlooks from the big research firms range from a market “melt-up” to a Wells Fargo call for a ten per cent correction. Even the CBOE Volatility Index (VIX) — known as the fear gauge — is offering few clues to the year ahead after ratcheting down by 40 per cent in 2019.
To further muddy the waters, market anxiety over a global trade war launched by an unpredictable U.S. administration persists, and could be amplified heading into the U.S. elections in November.
With so much uncertainty, 2020 could be less about ushering in the new and flushing out the old, and more of a year to merely shuffle what you have. Rebalancing a portfolio requires a broad view of the markets, skill in determining which investments to trim and increase, and timing. It is best done with the help of a qualified advisor, but there are a few basics to keep in mind before starting.
First, over the long term, diversification is always a great way to expose your portfolio to a wide array of opportunities while hedging risk. One of the most positive side-effects of a diversified portfolio that spans sectors and geographic regions is the ability to use the broader markets as benchmarks. If your portfolio weightings already mimic the broader markets there’s a good chance the sectors that have done well are now over-represented and those that have not done well are under-represented. As an example, the S&P 500 technology sector advanced 47 per cent in 2019, while the S&P 500 energy sector only rose seven per cent. If you held an equal dollar amount of equities in both sectors at the start of the year, your technology holdings outweigh your energy holdings. In that case, your portfolio can be rebalanced by simply trimming profits from technology stocks and topping up energy stocks.
It’s also possible the sectors and geographic regions that performed well in 2019 have been overbought and those that performed poorly have been oversold, and markets will also rebalance in 2020. Investment researchers gauge a market’s true or intrinsic value through a variety of metrics including the price-to-earnings (PE) ratio. The PE ratio compares company and sector earnings to current market prices. A stock price at any given moment reflects how much the market thinks a company can grow its earnings.
Many factors go into determining the right price-to-earnings valuation that makes a stock worth buying or selling, and that’s why it’s important to have an advisor with access to good research. One way to determine if a stock is over or under valued is by comparing its PE to other stocks in the sector, or historic PE readings.
As a broad example, the entire S&P 500 is currently trading at a price-to-earnings multiple of 24 times projected earnings — up from just under 20 in 2018 and way up from the decade low 15 in 2012. On the surface it seems like the price of the entire S&P 500 has gotten ahead of its earnings, but the outlook for future earnings growth could warrant a higher PE. In many cases it’s normal for some sectors to have higher PEs than others.
Rebalancing also has a personal element. As we age and get closer to retirement the need for a reliable income stream grows. That requires lowering overall portfolio risk by shifting assets from equities to fixed income over time. In most cases the 10-year bull market in stocks, combined with meagre yields from fixed income, have left many aging investors overexposed to equities and under exposed to reliable returns from fixed income.
The exact split between equity and fixed income depends on an individual’s situation; but, to make the point, a typical asset allocation for investors in their thirties would be 70 per cent equities, 20 per cent fixed income, and the remaining 10 per cent in cash. When they get into their forties, equity holdings would be reduced to sixty per cent and fixed income boosted to 25 per cent. By the time investors enter their fifties, equities should be lowered to about 55 per cent, with fixed income reduced to 30 per cent.
Of course, portfolio rebalancing is done over a long period of time and never really ends, but getting on it in 2020 is a good start.
Payback Time is a weekly column by personal finance columnist Dale Jackson about how to prepare your finances for retirement. Have a question you want answered? Email email@example.com.