Severe Bear Markets Ahead #2
A Tutorial on Portfolio Rebalancing
by Robert B. Gordon, Sc. D.
September 2, 2003
Since my recent return to publishing on FSO, an interesting trend has been the increase in e-mail from "bearish" brokers. The number is still small, but the views they express indicate some small progress in the advice available to their clients. I am encouraged by this small trend and hope it continues to increase.
I do read all my e-mail and attempt to answer as many as possible. My most frequent request from elders is how to convince their bullish children of the dangers ahead. And from adult children, the requests are how to change the rigid attitude of their parents. I always do my very best to offer helpful suggestions.
I thought it would be interesting to publish two e-mails that came within an hour this morning, of course with names deleted.
In this follow up to our previous essay, we are going to spend considerable time explaining the advantages of portfolio rebalancing and presenting in detail two different ways to do it. But first let's discuss several pertinent e-mails.
RECENT MAIL
Mr. Gordon:
I am trying to help my parents prepare for the current and future bear market as well as the future decline of the dollar. I respect what you have written about choosing an advisor as well as your other articles and will send some of this to them.
However, my parents are beginning to believe what a financial advisor from XYZ Co. is telling them. He is recommending managed small and large cap equity funds, federal agency bonds and a managed REIT.
Please let me know if there is any way to explain the pitfalls of these investments in a clear and easy-to-understand manner. I was also curious to hear who some of your favorite writers are and where I may find their articles. I look forward to hearing back from you!
CPA
Dear Dr. Gordon,
I discovered Jim Puplava's web site a couple years ago and have always enjoyed your articles. Your article today, inspired me to contact you. Except for fewer years under my belt (I'm 46), our life stories are cut from the same cloth. I started investing at UCLA in the late 70s (at 18 years old). I got lucky on a couple of stocks and have been hooked ever since. I tried using a broker, but was never satisfied. And that began a journey of self-study through all of the major disciplines, theories and charting techniques.
In 1988 I decided to merge my career with my passion for investing and became a broker. I was able to refine my investment timing skills to the point where I was able to correctly overweight government bonds in1999 and significantly underweight stocks. It was very difficult trying to keep clients out of stocks at the top of the mania. The ones who stayed with me were happy. The ones who left me got crushed. I lost quite a few clients to the bubble.
I have always tried to fight the tough fight and accumulate investments when they were undervalued and sell them when they were overvalued. The problem arises, because the system seems to be rigged to do just the opposite. Customers only want to buy investments after they've gone up and want to sell them after they've gone down. Likewise, brokerage firms and brokers find it easier to sell customers what they want to buy (at the wrong time).
I had been using inverse S&P funds in my own portfolios for a couple of years with good success and when I found out I could offer these short funds to my clients in a modest fee-based program at XYZ company, I jumped at the chance and moved to this firm last November.
As the only lonely "bear" in my office, I have found it best to keep my views to myself. The industry just doesn't want to hear it. I am doing the best I can to prepare my loyal band of clients for what's coming. I really like your allocations and also have my clients positioned in short government bonds, gold stocks, and for those who can tolerate it, the S&P inverse funds.
With the markets making marginal new highs, some of my clients are getting cranky--thinking maybe they've missing the rally of a life-time. Thus, when I saw your article today I wanted to contact you and thank you. It is so very difficult being a bear, when the government does everything it can to convince people "don't worry--be happy".
So, keep up the good work. And don't despair. I hear you and appreciate your wisdom and experience. God Bless You!
CFP
Associate VP
Financial Advisor, XYZ Co.
MY COMMENTS
It is interesting that the two XYZ companies mentioned above are the same large financial concern. In response to the CPA worried about his parents, I suggested that he have them read Robert Prechter's Conquer the Crash and The Ultimate Safe Money Guide by Martin Weiss Ph.D. Both of them were published in 2002, are fairly easy to read and understand and contain practical and useful information.
For people who are concerned investors and like to view charts, I also suggest Robert Prechter's prophetic At the Crest of the Tidal Wave written in 1995 and revised in1997. This book literally changed my life with its success story of the Elliot Wave Principle over the past 400 years of stock market history and its prediction of the slowly developing Great Bear Market and Depression to follow.
About the same time I was reading the two letters above, I received a joint phone call from 2 Vice Presidents in a brokerage office in the Phoenix area. I haven't had a business conversation with a broker for many decades, but this one was different. These two individuals commented favorably on my recent writings, said they liked my views and wanted to come visit me for a discussion. Before I knew it, we had set a date for the talk. We had a pleasant meeting that convinced me these men did understand the serious markets that lie ahead and were anxious to steer their clients safely thru them. I will be happy to hear from other like-minded brokers and to help them in so far as it is possible.
TAKING INCOME FROM A BEAR MARKET PORTFOLIO
I decided to cover this question from a reader separately because of it's great importance to understanding any bear market portfolio. In a major bear market such as the present, the main goal is not to lose your capital. This is best done by investing only in asset classes expected to gain over the long term. If dividend-paying stocks and interest-paying bonds are dropping in price, they are of no value to the investor desiring income. The only realistic alternative is to own the right asset classes, periodically take capital gains, either short or long, and treat them as income.
In our portfolio examples, we take capital gains every time we rebalance the portfolio. If it were done every year plus one day, any gains or losses would be long-term for tax purposes. We expect to receive net capital gains by carefully selecting every single asset class for its ability to go up on average during a long term bear market. We will provide some typical examples in the rebalancing discussion given later.
A MUTUAL FUND PLAN FOR THE LONG-HAUL?
In sharp contrast to our bear market portfolio is one now being offered by a well known no-load mutual fund company in its recent brochure. For the long-term ahead, they offer 3 portfolios with varying amounts of cash, bonds and stocks. Their conservative allocation holds 45% stocks, 45% bonds and 10% cash. The other two will hold 63% and 78% stocks with proportionately less bonds and cash--an almost sure road to the poor house in a long bear market where both stocks and bonds are going down.
The asset ratios in these 3 portfolios will be maintained, according to the brochure, by periodic rebalancing. But since there is so little cash, only 3% to 10%, there is no stable asset class to keep these portfolios from disappearing in the bear market years ahead. Our veteran readers will recognize the huge problems ahead with this conventional asset allocation. Will the so-called experts in our investment companies ever recognize they must prepare for a long brutal bear market? It is truly sad for me to see such a poor and mistimed offering from a major fund company. How can they not know that huge bear markets always follow stock manias such as the one that ended in 2000?
As we have mentioned in past essays, we do not expect to be alive when this bear market ends. While Wall Street salesmen and most investors call the start of a new bull market almost daily, we know this is utterly impossible. The charts of all prior stock manias from 1721 in London thru Japan in 1989, clearly show that they always end with prices below their starting level. The current boom and bust cycle, the largest in world history, started near Dow 1000 and should end at a lower level some time in the distant future. When the ultimate bottom is reached, there will be a high level of general disbelief of investing in stocks and an almost empty Wall Street.
BEAR PORTFOLIO PERFORMANCE DATA
We tabulate the performance below of our conservative portfolio described in our most recent essay. We show three performance values: (1) No rebalancing. (2) Annual rebalancing and (3) Rebalancing at certain price peaks and valleys. In each case, the data covers the period from 3/31/00 to 8/25/03. The composition of this portfolio is as follows:
| Short-Term U. S. Treasury Bonds | 30% | ||
| Short-Term Foreign Gov't Bonds | 30% | ||
| Reverse Index S&P 500 Short Fund | 10% | ||
| Reverse Index 30-Year Bond Fund | 10% | ||
| ASA Closed End Gold Fund | 10% | ||
| CEF Closed End Bullion Fund | 10% | ||
| Total | 100% |
| Performance of a $100,000 Portfolio from 3/31/00 to 8/25/03 | |||
| Asset | No Rebalancing 0 switches |
Annual Rebalancing 3 switches |
Peak/Valley Rebalancing 4 switches |
| U.S. Bonds | $32,100 | $37,971 | $43,164 |
| Foreign Bonds | $37,350 | $38,530 | $39,154 |
| Short S&P | $14,159 | $12,764 | $14,126 |
| Short Bond | $8,222 | $13,345 | $16,902 |
| ASA | $24,045 | $15,237 | $18,429 |
| CEF | $13,428 | $12,797 | $15,726 |
| TOTAL | $129,304 | $130,630 | $147,501 |
Please study closely these overall returns. With no rebalancing in the three and a half years, five of the six asset classes gained. So the portfolio did produce a significant amount of "income" even without any rebalancing, but the investor would have to decide when and what securities to sell for capital gains. Also note that the only losing asset class was the short bond fund which bottomed only in June of 2003 when the 21-year bond bull market ended.
Now, turn to the middle column where there were 3 rebalancing actions at annual intervals from the start date. These dates happened not to coincide with any major tops or bottoms in the charts of the 6 asset classes, so a modest gain was realized in the bear market to date. Note the large increase in the percentage of the short bond fund which should bring greater future gains. This was directly due to the rebalancing as shown later. In ten to twenty years of a continuing bear market, the gain would have been more substantial and the percentage of each asset class would be closer to their original planned amount. If the investor did not need to receive long-term gains and had rebalanced every six months, the overall gain would have increased and also the conformance to the original asset percentage would have improved. This is confirmed by the results in the third column.
For the third column we used our FastTrack charting service to put the 6 fund price charts on our computer screen. Over this bear market period there were several large price peaks in the ASA and short S&P charts. We chose to rebalance at peaks occurring on 9/21/01, 6/3/02 and 7/23/02. For the fourth rebalance we chose the very recent 6/13/03 bear market low in the short bond fund. We decided to demonstrate this better method; while realizing very well it is an academic exercise. In real time, one can never recognize a peak or valley immediately, but rebalancing within a week or two is possible when you gain familiarity with the market actions in the portfolio.
The longer this bear market portfolio is rebalanced by either method, the greater should be the overall gain and retention of asset class balances compared to a buy and hold strategy. Even when a calendar based rebalance program misses a major price peak or valley, the numbers will eventually smooth out. Of course there is nothing wrong with adding a special rebalance to a calendar program when a large price peak or valley occurs in a volatile asset class. With this overall background, we will now give the arithmetic steps needed for both types of rebalancing.
A TUTORIAL ON PORTFOLIO REBALANCING
Regardless of when it is done, each rebalancing activity requires these steps:
- At the start date, determine the initial starting dollar value and the number of shares in each asset class.
- At the first and subsequent rebalances, follow these steps:
(a) Multiply the prior number of shares for each asset class by it's price on the rebalancing date.
(b) Total the new asset prices and then multiply the dollar total by the original percentage of each asset class to get the new dollar amount for each class.
(c) Calculate a new number of shares for each class by dividing the new dollar amount from (b) by the share prices on the rebalancing date. - Repeat step 2 for each rebalancing date.
- After the final rebalance, multiply the number of shares in each class by their prices at any future date to get the total portfolio value.
- Significant price changes due to dividends and stock splits must be made when they occur. These changes are included in our FastTrack price database which covers 5700 funds of all types and is quite affordable. For a free trial go to www.fasttrack.com. They also provide free 800 phone help.
PORTFOLIO REBALANCING DATA
In the tables below, we will give the rebalancing details for the initial action in the calendar and peak/valley series. Later, we will report the portfolio dollar data over the full 31/2 year bear market period.
| First Calendar Rebalance | |||||
| Asset | 3/31/01 | # Shares | 4/1/01 Total |
Rebalanced Total |
New Shares |
| U.S. Bonds | $30,000 | 3000 | $31,260 | $30,301 | 2908 |
| Foreign Bonds | $30,000 | 2941 | $28,674 | $30,301 | 3108 |
| Short S&P | $10,000 | 1299 | $13,743 | $10,101 | 955 |
| Short Bond | $10,000 | 1111 | $9,501 | $10,101 | 1180 |
| ASA | $10,000 | 578 | $9,132 | $10,100 | 639 |
| CEF | $10,000 | 2857 | $8,685 | $10,100 | 3322 |
| TOTAL | $100,000 | $101,004 | $101,004 | ||
Please note in the table above that only two of the asset classes gained in the first year of the bear market. Distributing those profits to the lagging classes is the secret weapon of portfolio rebalancing. If you pick the right asset classes and buy more on their price dips, as this program requires, you are on the way to a happy future.
| First Peak Rebalance | |||||
| Asset | 3/31/00 | # Shares | 9/21/01 Total |
Rebalanced Total |
New Shares |
| U.S. Bonds | $30,000 | 3000 | $31,800 | $32,577 | 3073 |
| Foreign Bonds | $30,000 | 2941 | $30,292 | $32,577 | 3163 |
| Short S&P | $10,000 | 1299 | $16,367 | $10,859 | 862 |
| Short Bond | $10,000 | 1111 | $9,443 | $10,859 | 1277 |
| ASA | $10,000 | 578 | $10,404 | $10,859 | 603 |
| CEF | $10,000 | 2857 | $10,285 | $10,859 | 3016 |
| TOTAL | $100,000 | $108,591 | $108,591 | ||
In this tutorial example, the first exchange is made in a year and a half. We note an excellent growth and adherence to the original portfolio balance. Only the short bond is losing as it continues to do for a long time until June of 2003. But also note that we bought more shares and thereby increased future gains. Although these results are not fully attainable in real time, they can be approximated by rebalancing as soon as the peak or valley price is confirmed and also by acting on a greater number of the peaks and valleys.
Now that we have demonstrated how simple and straightforward rebalancing can be, we will give the entire rebalanced history of each portfolio discussed above. Please note the sequence of changes in the portfolio structure, always striving to regain the original percent of each asset class.
We will now tabulate the portfolio values at the beginning, each rebalancing and the end for your study. It is very important to note the ups and downs and the end status of these portfolios. Results of the annual rebalancing could have been duplicated by any reader; while the Peak and Valley example could have been closely duplicated with respect to the portfolio balance and approximated in the total value.
| Three And One Half Years of Calendar Rebalancing | |||||
| Asset | 3/31/00 | 4/01/01 | 4/01/02 | 4/01/03 | 8/25/03 |
| U.S. Bonds | $30,000 | $31,260 | $30,360 | $35,023 | $37,391 |
| Foreign Bonds | $30,000 | $28,674 | $30,769 | $43,087 | $38,536 |
| Short S&P | $10,000 | $13,743 | $9,999 | $13,936 | $12,764 |
| Short Bond | $10,000 | $9,510 | $10,372 | $9,125 | $13,345 |
| ASA | $10,000 | $9,132 | $18,646 | $13,293 | $15,237 |
| CEF | $10,000 | $8,685 | $13,122 | $13,193 | $12,797 |
| TOTAL | $100,000 | $101,004 | $113,268 | $127,657 | $130,650 |
| Three And One Half Years of Peak/Valley Rebalancing | |||||
| Asset | 9/21/01 | 6/03/02 | 7/23/02 | 6/13/03 | 8/25/03 |
| U.S. Bonds | $31,800 | $32,576 | $43,049 | $43,284 | $43,164 |
| Foreign Bonds | $30,292 | $33,530 | $45,440 | $52,668 | $39,154 |
| Short S&P | $16,367 | $9,913 | $16,132 | $10,723 | $14,126 |
| Short Bond | $9,443 | $10,190 | $11,929 | $11,397 | $16,902 |
| ASA | $10,404 | $23,457 | $13,588 | $12,746 | $18,429 |
| CEF | $10,285 | $13,874 | $12,807 | $13,076 | $15,726 |
| TOTAL | $108,591 | $123,534 | $142,945 | $143,894 | $147,501 |
Note: This portfolio is identical to the one above as of 3/31/00
FINAL COMMENTS
This essay was a real labor of love, trying to pass on what I have learned for the benefit of my readers. I have used a data source I have been using for many years and believe to be reliable. I cannot guarantee any of the figures in the tables because of the limitations of my eyesight and memory. Hand typing these tables was just about the limit of my present physical ability. So I hope the effort was worthwhile and that a number of readers will use some variation of portfolio rebalancing and enjoy a happy future by so doing. I hope you had a good Labor Day weekend while I was finishing this message.
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© 2003 Robert B. Gordon, Sc.
D.
Dr,
Gordon's Editorial Archive | Severe Bear Markets Ahead #1
Robert
B. Gordon, Sc. D.
Sun City West, Arizona
September 2, 2003
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