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Nevermind The Markets. Rebalance.


Once upon a time when someone asked ‘How are the markets?’ the answer was relatively simple. A Canadian stock jockey might have referred to a mining exploration ‘play’ or what Bank was going to merge with another. A U.S. analyst might have said the U.S. markets are up or down because of this or that. Pre-Euro investment comments might have referred to the peculiarities of an individual European country. (Remember Deutschmarks? Francs? Lira? Pesetas? Drachma? Shilling?). In any case, Canadian investors’ foreign investments were restricted.

Decisions were simple too. Stocks or Bonds? Are you a Bear or are you a Bull?

Decisions are more complex today. And they are complicated by the confusing array of product and fee choices and something called derivatives and hedge funds which are made incomprehensible a constant flood of often contradictory data delivered at the speed of technology change.

Making things even muddier is a fast-moving geopolitical and an uncertain political environment. (There are 12 major elections in 2012 … more on this later).

Just when the dust begins to settle, an unstoppable ‘macro broom’ sweeps investment strategies and predictions aside. The game changes in an instant and investors get caught offside by some guy in Europe (say) who disagrees with what was previously agreed to. ‘Hot’ money reacts and all markets move a previously unheard of 4% a day. Many investors get hurt no matter where they are invested or what they are invested in. Even the most seasoned investors have been challenged over the last five years.

In this macro-driven environment, one wonders how successful active investment management (stock picking) can be. Active management looks for differentiations between securities. But the macro backdrop overrides traditional valuation methodologies, correlations move to one and any differentiation goes out the window. The traditional valuation tools (and valuation rankings) aren’t as effective. (See also ‘This time it’s different … for Investment Managers’).

Key to many valuation models is the discount rate used to value future cash flows. One example of discounting cash flows is the Gordon Growth Model which discounts future earnings (dividends) in attempt to arrive at a stocks’ value.

<img src="Gordon Growth Model.GIF" alt="Gordon Growth Model" />

D = Dividend per share
k = Required rate of return (yield plus growth)
G = Growth rate in dividends

Institutional investors use an actuarial discount rate (a derivative of bond yields plus equity risk premium) as a required rate of return.  Corporate earnings after taxes as a percentage of GDP average 6% (roughly equal to economic growth). (See John Bogle, FAJ, v65.n1, Jan/Feb 2009). Well bond yields are at thirty-year lows and growth is subdued. There is ample opportunity here to debate cost of equity, weighted average cost of capital and corporate bonds as discount rates but the point is that the math doesn’t work as the denominator approaches zero. (Arguably, Japan has had a zero discount rate for 20 years. How that working out)? In this environment, many valuation models are (temporarily) broken.

Macro-driven markets mean that Indexing won’t work as well either. Investors will get what the markets give. Up and down. If neither active management nor indexing work as well in a macro-driven environment, what will?

The best defence is a rebalancing discipline. In fact, volatile markets are perfect for rebalancing. That’s next time.

Rebalancing pre-reading:  Buy low and sell high made easyEconomic tug-o-war will cause sideways drift.

Next time?
Rebalancing.
Doug Cronk CFA is Manager, Investments for a Canadian Pension Plan
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