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Asset Values Are Stretched – What to Do About it?

November 15, 2017
by Jack Reynolds

Asset Values Are Stretched

As financial asset values become increasingly stretched, it becomes ever-more important for investors to determine clearly their process for managing a potential correction in those values.

Investors and the media have talked about elevated financial asset values (not just U.S. equities, but investment assets broadly speaking) for some time. Rather than being remedied, the issue has been exacerbated.

Tactical asset allocation adherents might have investors reduce (long-term) investment exposures, increasing cash and short-term fixed income.

Philosophically and practically, that is not my inclination:

  • As a matter of investment philosophy, I don’t favor that approach, in part because the likelihood of making both exit and reentry decisions correctly in quick succession is low. Missteps in exit and reentry can be costly.
  • As a practical matter, the tax consequences of tactical asset allocation for private investors can be significant.

Accordingly, potential missteps in timing and the impact of taxes together present a daunting prospect for private investors who are considering tactical asset allocation as a solution to elevated financial asset values.

What, then, is a private investor to do? I advocate a five-pronged approach:

  1. Be mindful of the degree to which valuations are stretched, to avoid unpleasant surprises. Three articles may be of interest in setting the table for a further discussion:
    1. Wall Street Journal, “A Case for the Bulls Is Hard to Warrant,” by James Mackintosh, Oct. 13, 2017, at p. B-1/B-10, or online, “This Market’s Running on Hope, Not Profits.”
    2. The Economist, “Asset Prices Are High Across the Board, Is It Time to Worry?” Oct. 7, 2017.
    3. New York Times, Oct. 15, 2017, “Charging Past Chaos,” pp. BU-11/BU-17, or online, “The Stock Market Charges Ahead, Despite the World’s Storms.”
  2. Have enough cash, plus assured sources of cash (e.g., expiring Treasuries), to cover a year’s spending, including:
    1. taxes (income, gift, real estate, etc.),
    2. current pledges and anticipated charitable commitments,
    3. capital expenditures (college, acquisition of non-investment assets, etc.)
    4. life style maintenance, and
    5. alternative assets capital calls, without reliance on distributions, which could be temporarily impaired.
  3. Rebalance back to long-term asset allocation targets at least semiannually in a disciplined manner, reducing exposures that are above target and adding to exposures that are below target. There may be frictional considerations that inhibit your rebalancing, such as tax factors, cost bases, age and health. It may be wise to review your long-term asset allocation targets to be sure that they are suitable for your current and likely future circumstances. It is wise to conduct that review with a trained and experienced professional of your choice.
  4. When feasible from the point of view of taxation (and regulatory supervision for “insiders”), reduce legacy, or outsized, single asset exposure(s).
  5. As discussed in the referenced Economist’s article, heed Benjamin Graham in his The Intelligent Investor from 1949: invest with a “margin of safety.” Each of the measures above is designed to increase your margin of safety. Beyond that, emphasize active asset management over passive index-tracking when assets appear to be overvalued. While active management does not assure a “margin of safety,” it provides an opportunity for the creation of a margin of safety. If one pursues active management, the selection of those managers is hugely important. Vanguard’s research tells us that “. . . after costs: (1) the average actively managed mutual fund underperformed various benchmarks; (2) reported performance statistics can deteriorate markedly once ‘survivorship bias’ is accounted for (that is, once the results of funds that were removed from the public record are included); and (3) persistence of performance among past winners is no more than a flip of a coin.” Accordingly, once again, it may be wise to work with a trained and experienced professional advisor of your choice in selecting investment managers.

If you would care to discuss these, or other, topics with me personally, please drop me an email, or give me a ring at 617.945.5157.  And as always, we welcome your comments.