Heading into December, many investors start planning for the year-end
and prepping their investment portfolio for the year ahead. Most
of the time investors are primarily focused on the outlook for
the Market in the coming year, and while that is obviously important,
investors should also be thinking about re-balancing and taxes.
Let’s address these three issues in reverse order.
Taxes Do Matter, And Not Just In December
We have spilled a lot of ink talking about taxes in recent commentaries
(and expect more ink to be spilled in the years ahead) and for
good reason. Investors generally don’t realize that “tax
cost” is the largest “expense” for taxable
investors in mutual funds. That is, the average annual tax cost
(the difference between pre-tax and after-tax returns) for domestic
equity funds over the last 15 years is actually higher than the
average equity fund expense ratio.
Yet, typically, many investors don’t start to think about
taxes on their investment portfolios until December. We think this
is a mistake. One should think about taxes all year long. For instance,
if a position in a taxable account is trading at a loss in January,
there may be an economic value in taking that loss (“harvesting
a tax credit”) and/or executing a tax swap. In short, tax
planning should be a year-round exercise, not something just for
the closing weeks of the year.
This all said, worrying too much about taxes can be a problem,
as well. Many investors can’t bring themselves to sell a
position with a big capital gain — even if the primary investment
considerations (such as valuations, fundamentals or risk characteristics)
suggest that they should. In short, “don’t let the
tax tail wag the dog.”
For more on taxes, please refer to our past Research Perspective, “Debunking
Mutual Fund Tax Myths”
Rebalancing Your Portfolio
An important task is to periodically re-balance your investment
portfolio, bringing it back into alignment with its target portfolio
weights to keep it headed in the right direction. This is accomplished
by buying assets or market exposures that have underperformed
and selling those assets or market exposures that have outperformed.
Typical re-balancing programs are based off the calendar (annual
or quarterly rebalancing for instance) or off market movements
(for example when an asset class moves more than x% from its
target weight).
Over time, due to market movement, portfolio weights can start
to deviate significantly from targeted levels. And, if you don’t
rebalance, that can cause your portfolio to earn less than it should.
Let’s take a simplified example where an investor begins
the year with a weight of 75% in stocks and 25% in high-quality
government bonds which is consistent with their long-term goals
and risk profile. It’s a tough year for stocks because the
economy is weak and corporate profits suffer and the stock portion
of the investor’s portfolio declines by 30%. But the Fed
cuts interest rates to help get the economy going again and so
bond yields fall and the high-quality Treasuries the investor owns
rise by 13%.
At the end of the year then, the investor’s portfolio has
65% in stocks and 35% in bonds. This is well off his target asset
allocation, but the investor does not rebalance. The next year,
as often happens, the stock market rebounds nicely, rising 30%
as the economy starts to improve. Bonds on the other hand are flat.
I’ll spare you the math, but an investor who started with
a $1 million portfolio and did not rebalance after the first year,
would have earned about $24,000 less in that second year than an
investor who did rebalance back to the 75/25 target mix at the
beginning of the second year.
Yet, few investors rebalance even annually, and most don’t
re-balance at all! Of people who invest in 401(k) plans, according
to the Employee Benefit Research Institute, 86 percent don’t
rebalance. Also, according to Yale’s chief investment officer
David Swensen, even highly educated and extremely well informed
people with a significant degree of financial sophistication don’t
re-balance enough. In Swensen’s book, “Unconventional
Success”, he studied investors in TIAA-CREF. He found that
nearly nine out of 10 investors made minimal, if any, changes to
their new money allocations over a 10-year period.
How much does re-balancing “cost”? There are a variety
of studies on this point, and there are various time frames that
were examined. The answer is, as it is with many questions: “it
depends”. Nonetheless, one paper we looked at suggested the
annual cost of not re-balancing (depending on the time frame) was
0.5 to 1.3% a year. In short, an advisor that re-balances a portfolio
can pay for its management fee just by the simple act of re-balancing.
At Kobren Insight Management, we re-balance accounts at least
once a year. For non-taxable accounts we look to re-balance in
December. For taxable accounts, we look to re-balance in January.
We will, however look to re-balance at any time during the year
depending on market conditions.
Early 2007 Outlook Suggests Diversification Remains Key
In the broad strokes, our over-all market outlook has not significantly
changed that much in recent months. We remain cautious as many
factors that we look at in the economy and markets suggest that
caution is in order. Let’s just look at a couple factors – earnings
and valuations.
We have seen incredible earnings growth in recent years. Using
reported earnings from Standard & Poors on the S&P Index,
year-over-year earnings growth in 2003 was 77%. In 2004, the earnings
growth was 20%. In 2005, it was 19%. It is estimated to be 15%
in 2006. For a frame of reference, the long-term earnings growth
for the stock market is approximately 6%. Next year, the early
call is for 4% year-over-year growth.
As with many market factors, it is just not the absolute level
that is important, it is oftentimes the trend of the factor that
is even more important. While we have seen stock prices rise in
recent years, partially thanks to earnings growth being at least
twice long-term averages, the trend of earnings growth is for slower
growth – and for below average growth at that. All else being
equal, this is not a positive for the market.
It should also be noted that only a few economic sectors expect
to have better year-over-year earnings growth in 2007 than they
did in 2006: consumer staples, health care, information technology,
and telecommunications. What is interesting about these sectors
is that each of them has above-average representation in larger-cap
securities. While the rough rule of thumb is that the over-all
stock market is roughly 70% large cap securities in terms of market
capitalization, these sectors range from approximately 75% large
caps (information technology) to about 90% (telecom). These sectors
tend to have growth tilts as well (though consumer goods and especially
telecom have value tilts).
At present, our investment portfolios tend to be tilted towards
larger cap companies as well as toward growth stocks.
Regarding valuations, it is often stated that the stock market
is “fairly valued” since the price/earnings ratio for
the S&P is back near long-term averages. From where we sit,
however, it just isn’t this simple. There are a variety of
valuation metrics to use, and again the trend of the data is often
as important as the absolute level.
The S&P 500 price/earnings ratio, using operating earnings,
at the end of 2003 was 20.3. At the end of 2004, it was 17.9. It
dropped to 16.3 by the end of 2005. It is expected to be 16.0 at
the end of this year based off expected earnings for 2006. Using
earnings expectations for next year, the P/E is expected to be
14.6. Looking at individual sectors, each major sector is expected
to see their price/earnings ratio contract next year. Yes, P/Es
are not as expensive as they were, but they are still trending
lower. And, as we have mentioned in the past, they don’t
usually stop at average, but well below. Valuations cycle from
high to low to high to low to high and low — like nearly
all things in the markets.
Three Components to Stock Returns
In summary, when it comes to forecasting the stock market’s
returns, there are three components to focus on. First, is the
dividend yield (currently about 1.8% for the S&P 500). Second,
there is the growth in corporate earnings. Third, there is the
speculative component that comes from changes in valuations on
earnings (P/Es).
As mentioned above, while the long-term earnings growth for the
stock market is about 6%, the expected earnings growth for the
S&P 500 next year (using reported earnings) is 4%. Also, as
note above, when P/Es begin to decline they usually continue to
do so until they are well below fair value so lets assume a further
contraction of P/Es in 2007.
What does this leave for an expected return for the stock market?
Adding the dividend yield of nearly 2% to the earnings growth of
about 4% and factoring in a small negative bias due to valuation
(P/E) compression, that leaves an expected return of less than
6% for equities. Given that the yield for the Lehman Aggregate
Bond Index is just above 5%, this suggests two important things.
First, the value of diversification (i.e. holding bonds and other
securities as well as stocks) is as important as ever, especially
given that the expected return differential between stocks and
bonds is less than in years past.
Second, given that equities still have the higher long-term return
potential, growth-oriented portfolios should maintain healthy exposure
to the stock market for potentially higher returns.
Next month we will review how our annual list of potential surprises
(2006 version) fared, and boldly lay out our list of surprises
for 2007.
Sincerely,
Eric M. KobrenRusty Vanneman, CFA
PresidentDirector of Research
Portfolio
ManagerCo-Portfolio Manager
