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January 5, 2009

Portfolio Rebalancing - Don't Ignore Duration

John P. Hussman, Ph.D.
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The S&P 500 ended 2008 with a total return of -37%, while long-term Treasury bonds soared on fears of credit defaults and deflation. The yield on the benchmark 30-year Treasury dipped below 2.5% a couple of weeks ago, with 10-year Treasury yields plunging to about 2%. While stock prices are now moderately undervalued, and are priced to deliver reasonably good returns over the coming decade (regardless of shorter-term prospects), Treasury bond prices are currently buoyed by such a “flight to safety” that they have ironically become speculative investments themselves.

It is doubtful that long-term investors have any real intent of accepting a 2.5% yield over the next 30 years on Treasury securities having, if not default risk, substantial risk of price volatility. Accordingly, investors must believe that they will have the ability to hold these securities for a rewarding short-term holding period, and then sell them to someone else before prices drop. This is a mentality that we periodically observe in stocks during bubble periods, prior to massive corrections, but is one that we rarely observe in bonds.

The long-term Treasury market now requires near-depression economic conditions to justify prevailing prices and yields-to-maturity. In the event that the general level of risk aversion among investors eases, either the U.S. Treasury market or the value of the U.S. dollar will endure disproportionately large losses. As I noted last week, given the level of extension in yields, it would not be difficult to generate losses of say 10% in the 10-year Treasury bond, and as much as 20-25% in the 30-year Treasury bond over a very short period of time.

The relative performance of stocks versus bonds last year has had an important impact on durations, which investors should not overlook if they plan “rebalance” their portfolios in the weeks ahead (for a review of the concept of duration, see the February 23, 2004 comment Buy and Hold for the Duration?)

In order to understand the importance of the duration shift that we've observed over the past 15 months, recall that for a passive “buy-and-hold” investor having no view about short- or long-term market direction, the appropriate portfolio allocation strategy is to match the “duration” of the portfolio to the anticipated date that the money will be needed. So for example, an investor needing to use the funds in 5 years would tend to choose relatively shorter-term, less price-sensitive securities, while an investor having a 40-year horizon would typically choose longer-duration securities.

In 2007, the effective duration of a 30-year Treasury bond was just over 16 years. Meanwhile, the effective duration for the S&P 500 Index (which turns out to be essentially the price/dividend ratio) was nearly 60 years. At that point, in order for a passive long-term investor to achieve an expected long-term return of 7%, it would have been necessary to have a 60-year expected holding period, with a 100% position in stocks being the only passive investment allocation capable of achieving that result.

Equivalently, for an investor with only 20 years or so to invest, the largest appropriate allocation to stocks was only about 1/3 of the portfolio (i.e. 1/3 of 60 years = 20), provided that the balance of the portfolio was held in cash. For that investor, the reasonable prospect of 7% long-term returns was unavailable, without taking excessive risk. Even if one had no views about market direction, the extremely long 60-year duration of stocks in 2007 forced passive investors to accept a terribly limited menu of options, all with disappointingly low expected return prospects.

Fast forward to the present, and the situation has changed remarkably. With the recent surge in Treasury bond prices, the effective duration of a 30-year Treasury bond has climbed from just over 16 years to nearly 20 years. Meanwhile, the plunge in the stock market has collapsed the duration of the S&P 500 from nearly 60 years to just about 30 today.

For investors who rebalance their portfolios annually, this is essential information. Given the probable long-term returns that stocks and Treasury bonds are priced to deliver, an investor seeking a 7% long-term total return would currently require an allocation of about 60% in stocks and 17% in bonds, for an overall portfolio duration of about 21 years – only a third of the duration that an investor seeking that same long-term return would have had to accept just 15 months ago! Given the poor long-term returns that Treasury bonds are priced to deliver, an investor with any view at all about market direction would likely forego the 17% allocation to long-term bonds, opting for shorter-duration (and only slightly lower yielding) securities until the Treasury market normalizes.

Investors are sometimes urged to allocate a percentage of assets to stocks equal to 100 minus their age. In my view, this formula is terribly crude, because it ignores the impact of valuation on the duration of stocks. Again, at a dividend yield of 1.7%, stocks have a duration of nearly 60 years. At a dividend yield of 4%, stocks have a duration of just 25 years. Clearly – even for passive investors having no view about market direction – the appropriate allocation to stocks is inverse to their valuation. This point can be argued on the basis of duration alone.

For a 50-year old passive investor with, say, a 20-year investment horizon, the appropriate investment strategy isn't to plop 50% into the stock market regardless of valuation. At an S&P 500 dividend yield of 1.7%, as we saw in 2007, the duration of stocks was 60, so the appropriate allocation to stocks for that investor was no more than 33%. At an S&P 500 dividend yield of 4%, it could comfortably rise as high as 80% (20/25), provided the balance of the portfolio was in cash, which has zero duration. Given current valuations, the appropriate allocation – again for a passive investor with a 20-year horizon – could be as high as 58% in stocks, provided that the remainder of the portfolio is in fairly short-duration, low-volatility securities.

For our part, we believe that valuation and market action can be effectively used to actively manage market exposure over the course of the market cycle. In that context, the improvement in valuations since 2007 has removed the need to fully hedge our investment holdings on an ongoing basis. So regardless of whether investors are active or passive, the decline in market valuations over the past 15 months has been a very favorable development, and allows even conservative investors to accept a greater amount of stock market exposure than they have been able to take in quite some time.

Market Climate

As of last week, the Market Climate for stocks was characterized by favorable valuations and modestly unfavorable market action. Early improvement in market internals has continued to the point where continued follow-through could provide evidence of fresh willingness among investors to accept risk. We're not quite at that point yet, and we are almost certainly facing continued economic challenges, so the improvement in market internals remains somewhat tenuous for now. Our current “line-in-the-sand” so to speak is about the 850-900 level on the S&P 500. Above that level, which is the area where our defensive strike prices are staggered, the Strategic Growth Fund will tend to participate in both advances and declines in the general market. If the recent advance fails sharply or abruptly, our participation in market fluctuations will become increasingly muted below about the 850 level on the S&P 500. At present, market conditions remain generally constructive, and while we don't have enough evidence to remove hedges outright, we also aren't inclined to quickly tighten hedges and take profits in response to moderate advances (something we would do to a greater extent if we begin to observe weakening or divergent internals).

In bonds, I continue to be concerned about the unusually depressed level of nominal Treasury yields, in that any easing of risk aversion could send straight Treasury bond prices down sharply, especially at long maturities. For our part, the Strategic Total Return continues to be invested primarily in inflation-protected Treasury securities of moderate duration, with about 10% of assets in precious metals shares, about 5% of assets in utility shares, and about 10% of assets in foreign currencies.

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