There are few, if any, variables that provide solid evidence of predicting short-term asset prices. One powerful force over the long-term that investors should consider when rebalancing portfolios is mean reversion.
Similar to how a sine and cosine wave peak and trough around a mean, asset prices often perform in a similar manner relative to one another. Outperformance today is often the expense of future performance when compared to other assets, such as stocks versus bonds or vice versa.
Before we look at the trailing results as of the end of December 2013, let's check where these metrics stood on December 31st, 2008. Since we are looking at where the best opportunities are to add capital versus where to avoid, I chose green as the lowest performing asset color and red as the highest. Thus our eyes would be drawn to adding to the areas that underperformed, just as a mean reversion investor prefers. Each 1-year, 3-year, 5-year, and 10-year period is ranked by color for each column. I prefer to key in on the three and five-year periods, as these are the intermediate time frames many investors examine when evaluating mutual funds or money managers.
Five years ago, the S&P 500 had a negative trailing return across all time periods shown; of course this was the midst of the financial crisis. Nevertheless, US stocks sure had plenty of green indicating attractive entry relative to other asset class. Bonds, with the exception of high yield corporates, had mostly an orange and red hue.
The returns ending in 2013 look quite different. Equities and high yield bonds are the hottest asset classes while the greenest areas are bonds and alternative investments such as hedge funds. Over the past ten years, emerging markets were the second best performer, yet the worst over the past three. REITs on the other hand stayed warm over the last three, five, and ten-year periods.
This is not a directive to sell equities, though I am sure portfolios that took no rebalancing action during 2013 have much more in U.S. stocks than they had a year ago. This is an exercise to look at where underperformance occurred to take advantage of the mean reversion tendency of asset classes. Let's examine which stock sectors were the leaders and laggards over the trailing periods.
During 2013, industrials, healthcare, and consumer discretionary were the best sectors to be, with consumer discretionary by far the best area over the last five years. Instead of buying houses like the last cycle or saving excess cash the past few years, the U.S. consumer clearly love spending and kept it up. The laggards over the last three year period appear to be energy, materials, telecom, and utilities – with the last two the lowest on a five-year basis. Financials stand out on a ten-year basis as the sector climbs out of the hole dug during the 2008 financial crisis. This is a reason the value indices lagged against growth (in the above chart), since the financial sector makes up a high weight.
Balanced portfolios hold combinations of asset classes to diversify risk. While it is tempting to look at the previous year's winning asset class and expect the trend to continue (see The Psychology of Rebalancing), mean reversion is important. Peeking back at longer time frames for the asset classes that might be out of favor could bring opportunity. This allows investors to 'buy low and sell high' and rebalance portfolios back to the long-term strategic targets.
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