A time to take profits

Taking profits now, or reinvesting them, makes sense to manage risk in view of local and global events.

Summary: The Australian market has recorded solid gains, but concerns remain and the local equities market is more vulnerable to a correction. Investors should consider taking profits, or reinvesting them, to maximise growth and minimise the risks from any downturn.

Key take-out: If Australian companies fail to grow earnings en masse and if the market stays range bound, a rebalancing strategy can manage risk and potentially increase returns.

Key beneficiaries: General investors. Category: Portfolio construction.

Japan expert Robert Feldman described Japan’s post-bubble economy as following a repeating “CRIC” cycle – (C)risis followed by government (R)esponse, which leads to (I)mprovement then (C)omplacency until crisis re-emerges.

You could argue world financial markets are now following this same cycle and were in a complacency phase up until the recent disturbing events in Cyprus. Investors are now listening carefully for a crisis-like chirp from elsewhere in Europe to suggest they should take flight from equity markets altogether. Here I’ll make the case that taking, or at least re-arranging, profits makes sense regardless of which way events unfold – assuming, of course, you are an investor who fully participated in the recent equity rally and aren’t still underweight.

The recent rally in the Australian sharemarket since June 2012 has been pleasing. Chartists would note, however, the broader market index is possibly still stuck in a four-year sideways trajectory bounded roughly between 4,000 and 5,000 index points and a “melt-up” isn’t guaranteed. Rather than try to divine the future from the past, let’s instead look at the fundamental drivers. The following chart shows earnings of Australian and US listed companies, the multiple of price (or P/E) investors are willing to pay for them, and the resulting prices of the two main indices for the last three year. To see this chart for Australian shares over the last 50 years click here.

This chart shows the recent rise in the Australian sharemarket has been driven not fundamentally by company earnings growth but by an emotional rise in the market’s price/earnings (P/E) ratio – shown by the flat green arrow next to earnings and the rising green arrow next to P/E. In fairness, that emotion could be a reasonable “greed” for higher income from dividends and “fear” of future financially repressive interest rates.  Our market is different to the US, where listed companies there have been growing their earnings more to justify their rising share prices. The increase in US P/E has been much more modest and now is unusually less than for Australian companies. Australia’s P/E is now relatively high for a bank-rich market which traditionally trades at a discount, reflecting the risks of thinly capitalised banking and a post-boom outlook for miners. This means the Australian market is much more vulnerable to a correction than the US market. Dividend buying investors, who are partly responsible for pushing prices up, need to except that your extra income could be funded by capital loss in the future unless corporate earnings catch up.

In 2010 I wrote (Get ready to rebalance) about the importance of managing the risk of having too much equities, and too little, by using a disciplined rebalancing strategy. After the latest run in share prices, even after reversals of the last few weeks, it is possible that many investors have become materially overweight in equities and should consider taking some profits. For instance, if you target having a simple portfolio 50% invested each in shares and deposits in July 2012, this portfolio would now be 55% in shares or about 10% more shares than for your target allocation (i.e. excess 5% divided by 50%). To keep your portfolio in balance you would sell 10% of your shares.

Should Australian companies continue to fail to grow earnings en masse and if the market stays range bounded in price, then a rebalancing strategy could not just manage risk but perhaps increase return. Had you rebalanced your portfolio every six months over the last three years you would have enhanced returns by about 1% (or 0.3% annually). Of course, you would have made more money if you had the perfect foresight to take profits in early 2010 and 2011 when the market was trading optimistically at 5,000 and bought more shares when it traded pessimistically at 4,000 in early to mid-2012. This strategy perhaps we could call the CRICket strategy – Buy on crisis, sell on complacency.

While your default position should be to adjust your portfolio to its “Strategic Asset Allocation” (SAA) or target percentage mix of assets, it might make sense to adjust this practising the difficult art of “Tactical Asset Allocation” (TAA).

At the risk of complicating an otherwise simple rebalancing message, consider whether ...

  • You should still have a little more equities in your portfolio than you normally would given the generational and interventionist low cash rates and bond yields. Perhaps the 5% rise in your equity/bond-cash mix since July 2012 positions you automatically to a more reasonable, hotter equity set point temperature (provided you can handle the heat of volatile equity returns). This is especially if you were underweight shares and you also (Prepare for modest medium-term growth) worry about modest returns over the medium term.
  • You should adjust your mix of Australian versus International shares. Perhaps this should be closer to 50/50 than the more commonly observed 60-100% of shares in Australian companies. Remember, the Australian market which guides many investors is nearly two-thirds debt and dirt and is not terribly diversified or defensive, as I pointed out earlier (Goodbye to the All Ordinaries). The P/E ratio of the local market is pricey compared to offshore. Further, our “Steven Bradbury currency” should fall over one day, which means that having money in offshore priced assets could help you protect better your standard of living and overseas holiday plans.
  • You could also trade some profits in growth and high-yield (including bank) stocks for more holdings in defensive companies. This you could do locally or overseas using a few exchange-traded funds.
  • If you’re uncomfortable trading equity for defensive bonds or deposits, then consider instead increasing your exposure to listed commercial property and infrastructure (Infrastructure’s game plan).
  • Rather than buying traditional fixed-rate bonds with your rebalanced profits, as many institutional investors would, maybe having more money in local deposit will help you avoid an interest rate rise – though I think that is far off. The current spread of term deposit rates over the bank rate equals the return from making less secure loans to companies, so it’s not clear to me that you need to go on a high-yield bond (fund) hunt. Inflation-linked bonds or annuities still seem a reasonable diversifier to rebalance into.
  • It is unlikely that most have made enough profits in their share portfolios to fund buying a direct property. For some, this asset class might nevertheless make up a third of their portfolio. However the events in Cyprus remind us of the creativity by which needy governments can tax “immovable” assets. In Australia, relative to other assets, investment property is punitively taxed on a combined asset and income basis by three different levels of government. If you worry that debt and democracy don’t mix, then perhaps your rebalanced profits need to find a way into less-easily confiscated assets like collectables including art or gold coins (Super safe investing: What you need to know).

While you may have quite a strong view about which asset classes you want to favour and to avoid, it may pay you to be humble. According to fund manager Schroder, the amount of government intervention in the world economy since 2008 totals $20 trillion – an amount so unprecedented that unintended consequences could easily emerge.

As a lesson from history, British governors in Colonial India introduced a bounty on cobra snakes to encourage their removal from the streets. This worked well until it was later discovered entrepreneurs were breeding them for reward. When the government then ceased the bounty, breeders let go of all their poisonous snakes on the streets, increasing their numbers above those originally to be removed.

This story can be retold using rat tails in Vietnam (click here) and fox pelts in Australia, and perhaps again in our modern financial system. So beware of the unexpected and keep your portfolio balanced against unexpected risks so as to not get bitten!
Graph for A time to take profits

Dr Doug Turek is Principal Adviser of family wealth advisory and money management firm Professional Wealth (www.professionalwealth.com.au).

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