FINANCIAL MARKET UPDATE 2.16.2021

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

THE IMPORTANCE OF REBALANCING

The stock market has some serious momentum. After ending last year at an all-time high, the S&P 500 has continued to rally and has closed at a new record in 10 out of 29 trading sessions in 2021. While investment portfolios have undoubtedly benefited from the strong market returns, the rapid pace of gains has introduced a new risk for many investors.

A properly diversified portfolio will see its investment across asset classes deviate from their intended weightings over time. For portfolios that include both stocks and bonds, the strong market returns experienced in recent months have likely led to a larger stock allocation than originally intended. A major implication of this is that the portfolio becomes riskier than an investor’s financial plan would otherwise dictate. Fortunately, there is a simple and effective way to address this problem: rebalancing.

Rebalancing offers investors a systematic way to manage risk within portfolios, and at times can improve returns. Vanguard demonstrated the efficacy of a rebalancing program with the chart below. In it, they compared two portfolios with 60% stocks and 40% bonds. One portfolio implemented quarterly rebalancing (blue line), while the other never rebalanced (gray line). The top half of the chart shows the size of the equity allocation leading up to and following the Financial Crisis of 2008. A few things to note:

  • The gray (non-rebalanced) portfolio saw its equity allocation gradually increase leading up to the financial crisis (yellow bar). As a result, the portfolio took on more risk than intended when stock prices began to fall.
  • The blue (rebalanced) portfolio took some chips off the table ahead of the sell-off and actually purchased more equities during the sell-off.
  • As a result, the blue portfolio was in a superior position to withstand the volatility during the drawdown and was able to take better advantage of the subsequent market rebound.

The bottom portion of the chart depicts the net effect of the rebalancing decision(s) on the portfolio’s values, with the rebalanced portfolio outperforming by about 5.0% over the full period!

There are a variety of ways to implement a rebalancing program. One method is referred to as calendar-based rebalancing. Under this approach, an investor determines in advance how frequently the portfolio will be rebalanced. Typical options include monthly, quarterly, or annually. Another popular method is based on tolerance bands. Under this approach, the investor determines how far out of balance certain asset classes will be allowed to move in the future. Moving out of the tolerance band acts as a trigger to rebalance the portfolio.

Studies have shown that it does not matter which method you choose for rebalancing portfolios, so long as an approach is selected, applied consistently, and implemented in the most cost and tax efficient manner possible. Measures that can be taken to reduce the cost and taxes of rebalancing include:

  • Contributing new cash to the portfolio to increase underweight positions.
  • Utilizing dividends and interest payments to rebalance underweight positions.
  • Aggressively rebalancing non-taxable accounts
  • Partially rebalancing by getting asset classes back into tolerance, but lowering costs by not taking them all the way to target.
  • Charitable gifting

A rebalancing program offers an excellent way to take the emotion out of investment decision-making. When markets are at an extreme, it can be incredibly difficult to make the necessary moves to keep your portfolio in-line with your financial plan. The rules-based nature of rebalancing can mitigate the pain that accompanies taking chips off the table during a rally or buying more stocks during a downturn. The result is typically a reduction of portfolio volatility and an improvement to risk-adjusted returns.

 

WEEK IN REVIEW

  • The price of the US oil benchmark West Texas Intermediate (WTI) has moved above $60 for the first time since early 2020 and is up 24% so far this year. The most recent leg up in price is related to the extreme winter weather being felt by a large portion of the country. In general, energy demand is elevated, while the frigid temperatures have taken some energy supply offline.
  • So far, 74% of S&P 500 companies have reported earnings for Q4 2020. 80% of these firms have beat earnings estimates, while 78% of companies have beat revenue estimates. The portion of companies beating on earnings and revenue is higher than average. The blended earnings growth rate using companies’ actual reported results and estimates for companies that have not yet reported has increased to 2.9%. This figure was 1.8% as of last week and -9.3% as of 12/31/20. With stock market valuations appearing stretched, continued increases in the growth of earnings will likely be needed to justify further market gains.
  • Important data to watch for this week include retail sales, industrial production and the Minutes from the previous FOMC meeting on Wednesday, jobless claims and housing data on Thursday, and an early look at February services and manufacturing activity on Friday.

HOT READS

Markets

  • If Tesla Bubble Bursts, Catastrophe Won’t Follow (WSJ)
  • How the Stock Market Works Now: Elon Musk Tweets, Millions Buy (Jason Zweig)
  • US Consumer Prices Increase Steadily in January (CNBC)

Investing

  • GameStop Investors Who Bet Big – and Lost Big (WSJ)
  • Best Story Wins (Morgan Housel)

Other

  • How to Avoid Phishing Emails and Scams (Wired)
  • Business of Football: Impact of Super Bowl Ratings Drop, Russell Wilson, JJ Watt (Sports Illustrated)
  • Why You Should Practice Failure (Farnam Street)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

ECONOMIC CALENDAR

Source: MarketWatch

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ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

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JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 10+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. In addition, he is responsible for portfolio trading, investment research and thought leadership for the division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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