Portfolio rebalancing is the process of realigning the weightings of a portfolio of assets to maintain an original or desired level of asset allocation.

The importance of portfolio rebalancing cannot be overstated, as it helps investors manage risk, capture gains, and stay aligned with their long-term investment goals.

Currently, we are witnessing a significant disparity in performance between various asset classes.

Over the past five years, stocks, particularly large-cap US stocks, have vastly outperformed bonds. Year to date, the trend continues with stock indices in positive territory while bond indices show losses.

Given the substantial outperformance of large-cap US stocks relative to everything else, now is an opportune time to trim some of those winning positions and redeploy those assets toward underperforming ones such as bonds.

The Rationale Behind Periodic Portfolio Rebalancing

Maintaining Desired Risk Levels:

Rebalancing helps maintain your desired level of risk. When one asset class significantly outperforms others, your portfolio's risk profile will shift. For instance, if stocks have outperformed and now represent a larger portion of your portfolio than originally intended, your portfolio is now more exposed to stock market volatility and probably higher overall risk.

Avoiding Overexposure to Overperforming Assets:

By periodically rebalancing, you avoid overexposure to any single asset class. Overexposure can be risky, especially if the overperforming asset class experiences a downturn. Rebalancing allows you to capture gains from high-performing assets and reinvest them in undervalued assets, enhancing overall portfolio stability.

Capturing Gains and Reinvesting in Undervalued Assets:

Selling high-performing assets and buying underperforming ones can seem counterintuitive, but this practice allows you to buy low and sell high. This approach can improve long-term returns and reduce portfolio volatility. Capital markets exhibit trends over the short term, but eventually “mean reversion” has a strong tendency to play out over longer horizons.

Current Market Analysis - Why Now is the Right Time

The current market conditions make a strong case for rebalancing. Large-cap US stocks have reached high valuations, with the S&P 500 trading at elevated levels relative to historical averages.

Conversely, bonds have underperformed, presenting an opportunity to buy these assets at lower prices.

The historical performance of market cycles shows that periods of high valuation are often followed by corrections or periods of lower returns.

Therefore, reducing exposure to overvalued stocks and increasing allocation to undervalued bonds and other assets can position your portfolio for better risk-adjusted returns.

Reason #1: Extended Valuation of US Large Cap Equities

The S&P 500, our proxy for large-cap stocks, is currently trading at a price-to-earnings (P/E) north of 26 times. In comparison, US Small Caps trade at a P/E of 16, and international equities are even less expensive than that.

Part of the reason for this premium valuation relates to the greater relative profitability and growth of large-cap stocks, but the degree of over-valuation is more of a reflection of inflated sentiment especially towards the top end of the capitalization aka the “Magnificent Seven”.

Reason #2: Significant Outperformance of US Large Cap Equities:

Over the last 5 years, US large Cap Equities have been the standout performer. The S&P 500 has returned 15.3% annualized compared to essentially flat for the US Aggregate Bond Index.

US Large Cap stocks have trounced not only bonds but also every other major sub-asset class within the equity universe. For example, International Developed Markets (EAFE) returned 7.7% annualized over the last five years.

Nothing has come close to beating the S&P 500 in the last five years. Even Commodities, typically the largest beneficiaries of an inflation boom, have not kept up with large caps.

US Large Cap Equities have not only outperformed every other major asset class but have also vastly exceeded our fundamentally-based expectations. Our return projections for US Large Cap are for a 9% annualized return. Our forecasts are primarily off due to underestimating the valuation multiple (P/E). In other words, investors have bid up US large-cap stocks beyond historical valuation norms.

A reasonable expectation is for the gap in performance between US large-cap equities and everything else to narrow over the coming year. We are not predicting a bear market, but rather greater price appreciation in other asset classes such as Emerging Market Equities and US Small Cap.

We also believe that the gap in performance between US large-cap and US bonds will compress to more historical norms. Based on our current forecasts we expect stocks to outperform bonds by 3 to 4% per year, not 15% like we’ve seen over the last five years.

Reason #3: The Opportunity to Enhance Portfolio Diversification

As U.S. large-cap stocks have experienced a prolonged period of outperformance, their weightings within many portfolios have likely increased substantially. While this may have boosted returns in the short term, it also introduces concentrated risk and potentially exposes investors to heightened volatility should market leadership shift.

By rebalancing away from these overpriced U.S. large-cap stocks, investors can effectively trim their exposure to this dominant asset class and reallocate those proceeds into other undervalued or underrepresented asset classes.

This process of diversification can potentially reduce the overall risk profile of a portfolio when investing in asset classes with lower levels of correlation to the S&P 500.

Currently, Emerging Market Equities represent one such opportunity to lower overall portfolio risk and reduce concentration.

Another asset class with enhanced diversification benefits is US bonds. The correlation between US large-cap and US bonds is below 0.5 creating an opportunity to cut back on overall portfolio risk significantly.

Diversification works by spreading investments across different asset classes that may respond differently to various market conditions and economic factors.

By holding a well-diversified mix of stocks (including small-cap and international equities), bonds (government, corporate, and international), real estate, and commodities investors can mitigate the impact of any single asset class or market segment underperforming.

Implementing a Rebalancing Strategy

Rebalancing is a crucial component of a well-designed investment strategy, helping investors maintain their desired asset allocation and risk profile over time.

However, the implementation of a rebalancing strategy is not a one-size-fits-all approach. There are various methods and triggers that investors can consider, each with its own merits and trade-offs.

One common approach is to rebalance based on asset class performance. As different asset classes exhibit divergent returns, their weightings within a portfolio can drift away from the initial target allocation. By monitoring these shifts, investors can identify when certain asset classes have appreciated or depreciated significantly, prompting the need for rebalancing. This method is driven by market dynamics and can help investors capitalize on mean reversion tendencies in asset prices.

Another factor that may trigger rebalancing is changing volatility and correlations among asset classes. As market conditions evolve, the risk profile of a portfolio can shift due to changes in the volatility and interrelationships between asset classes. Monitoring these shifts can help investors determine when rebalancing is necessary to maintain their desired risk exposure.

Many investors prefer a more systematic approach, implementing periodic rebalancing on a predefined schedule, such as semi-annually or annually. This method eliminates the need for constant monitoring and ensures that portfolios are regularly realigned with their target allocations, regardless of market conditions. However, it may also lead to more frequent trading and potential transaction costs.

A common guideline is to consider rebalancing when the current asset allocation deviates significantly from the target weights.

While there is no universal consensus, a common rule of thumb is to rebalance when the current mix deviates by more than 5% from the target weights. This threshold helps strike a balance between maintaining the desired asset allocation and minimizing unnecessary trading costs.

Steps to Rebalance Your Portfolio:

• Assess your current asset allocation relative to your target allocation. If you are off by more than, say, 5% from the target it’s time to consider re-balancing.

• Identify overperforming and underperforming asset classes. Assess if the situation is likely to continue. Are markets trending aggressively, or is mean reversion more likely in the future?

• Sell portions of overperforming assets and buy underperforming ones to realign with your target allocation. Consider tax implications but don’t let hate of taxes stop you from making the required changes.

Practical Advice for Diversifying:

• If you are an equity-oriented investor: Sell a portion of your US Large Cap Equities and reinvest the proceeds in Emerging Market Equities or US Small Cap Equities.

• If you are looking to reduce the risk of your portfolio: Sell a portion of your US Large Cap Equities and reinvest the proceeds in intermediate-maturity US Bonds or Money Market funds.

• If you are happy with your target allocations but your mix has drifted: Sell a portion of your out-performing assets and use the proceeds to increase your exposure to underperforming asset classes. Get back to target. Don’t micro-manage your timing.

It's important to note that rebalancing strategies should be tailored to an investor's specific risk tolerance, investment horizon, and overall financial goals.

Additionally, factors such as tax implications and transaction costs should be carefully considered when implementing a rebalancing strategy.

The Big Picture:

• Investors experienced a down week last week.

• US Large Cap Equities was flat and everything else was down.

• The big losers last week were Real Estate investors as expectations for a Fed cut were dashed as economic growth indicators came in higher than expected.

• Year to date US Large Cap Equities and Commodities are the best performing asset classes.

• The investment environment remains risk-on. Aggressive asset allocation strategies continue their outperformance.

Economy:

• The US economy continues to be whipsawed by changing growth and inflationary expectations.

• A couple of data reports last week pointed to a resurgence in growth as well as higher inflation.

• Investors seemed to infer that any interest rate cut by the Fed would be further delayed. The probability of a rate cut in June is essentially zero. There is now a 46% chance of a cut in September.

• Among the G7 countries, the US is growing the most at the moment with only slightly higher rates of inflation. That’s a good thing!

Equities:

• US Large Cap equities were flat last week with the Russell 2000, our preferred Small Cap Index, down 1.2%.

• International stocks also had a down week with Developed Markets losing 1% and Emerging Markets down 1.5%.

• In terms of sectors, only Tech and Communication Services had positive returns last week.

• The worst-performing sectors were Real Estate and Energy.

• On the international front, all major markets except for the US (flat) experienced losses last week.

• The resurgence of Chinese stocks was put on hold as investors grew more concerned about the path of interest rates in the US and remained skeptical of policy measures designed to revive the moribund Chinese housing market.

Bonds:

• The Federal Reserve does not seem to be in a hurry to lower rates anytime soon.

• I guess that we get max one rate cut this year but market participants seem to want more. As long as this stand-off continues don’t expect bond prices to change much.

• Investors should be focused on yield as the primary source of return.

• As such the short-end of the yield curve looks more attractive than buying into long-maturity bonds.

• Credit is also more attractive than Treasuries in light of solid economic growth.

Alternatives:

A Bit About Copper:

• Despite headwinds from slower global GDP growth, the copper market has tightened substantially due to a lack of supply and an unexpected snapback in Chinese demand.

• Due to labor and operational issues, there have been major disruptions to copper mine supply from countries like Chile, Peru, and Panama.

• Copper inventories have hit multi-decade lows after years of underinvestment in new mines and smelter capacity.

ETFs To Consider: COPX, CPER

Stocks To Consider: FCX, SCCO, BHP, RIO

Signal Versus Noise

What’s Coming on Premium Wednesday😀 

• Asset Allocation Performance - Portfolio Implications

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