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Jason Stipp: I'm Jason Stipp for Morningstar. As part of Morningstar.com's Retirement Portfolio Check-up Week, we're helping investors assess their asset allocations, their individual positions, and also size up some of the risks that might be lurking in their portfolios. And with stock and bond markets both performing well over the past five years, there could be some of those risks lurking. Here to talk about that is Morningstar's Christine Benz, our Director of Personal Finance.
Christine, thanks for being here.
Christine Benz: Jason, great to be here.
Stipp: It's almost counterintuitive that when markets are doing well, that risks start to get baked into them, but that is the case, especially when it comes to valuation, and you say valuations are one of the first risks that you really want to size up in your portfolio right now.
Benz: That's right. So you can look at valuation on sort of a macro level. When we look at the typical company that our analysts cover, the price to fair value is 1.03. Not egregiously expensive, but by other measures, stocks do appear somewhat expensive. The Schiller P/E, which is a cyclically adjusted price/earnings ratio. Historically, has been in the neighborhood of 16. Right now it's 27. A lot of people who are valuation conscious have been pointing to that as a potential red flag for equity valuations. But I do think it's a great time to step back. Just from a common sense standpoint, we probably will see some reversion to the mean. We've been through a period where equities have performed very, very well for a long period of time. We are starting to see some volatility here in 2015's early innings. I think it's only reasonable to expect that we will see more volatility ahead.
When we do have those periodic market shakeouts, they tend to affect the most highly priced pockets of the market the most. So those are the things that go down the most. I think that that pattern will probably persist in the years ahead.
Stipp: So many signals are pointing to at least a fully-valued market if not an overvalued market. So looking at that, what should I do about that risk? It does seem it is a pertinent risk right now.
Benz: Absolutely, so the key thing you want to do is look at your total asset allocation, like our X-Ray tool for getting a read on your portfolio's current asset allocation, compare it to your target. For many investors who have been pretty hands-off with their portfolios, that's been a very good thing over the past five years you've been better off just kind of letting your equities ride. But I do think periodic rebalancing can make a lot of sense. So consider rebalancing back to your targets, that's job one.
For most investors that will require them to kind of hold their nose and rebalance because chances are if they have bonds in their portfolios, that bond piece will have slumped, they'll have to top that piece up.
As well as foreign stocks, foreign stocks have underperformed U.S., there are a lot of gloomy looking headlines coming out of foreign market certainly in Europe as well as slowing growth in emerging markets. But I think there again investors have reason to consider scaling back their U.S. equity exposure in favor of perhaps foreign stocks or bonds.
Stipp: So assuming that my situation hasn't changed and my targets are still correct, I should rebalance back to those targets, but I shouldn't necessarily exit stocks or change my plan just because markets look a little overvalued?
Benz: Absolutely not. So in addition to doing that rebalancing check, comparing your asset allocation to your target; you also want to look at your intra-asset class exposure, your intra-equity exposure. I think it's reasonable given the robust returns we've seen from stocks for so long that investors should shade their portfolios toward the value side of the style box. I think some would argue that that's a reasonable thing to do all the time. But particularly right now, when we isolate the value companies in our coverage universe, typically we see lower price to fair values there as you would expect than on the blend and growth sides of the style box.
So I think that that's another thing to think about in addition to looking at that asset class exposure from a macro level, also look at what you've got going within your equity portfolio.
Stipp: And you maybe want to tilt away from some areas that look overvalued or maybe even more overvalued than the market as a whole?
Benz: Potentially so. So, when we look at the most overvalued sectors again based on our bottom-up look at the companies price to fair values, what we see is some level of overvaluation in the utilities that's the most highly valued sector, the most overvalued sector according to our equity analysts currently. Real estate is another spot where our analysts think generally the REITs are a little bit ahead of themselves. Consumer defensive and the healthcare sectors would be two other areas that investors might consider trimming. Performance has been very, very good but perhaps it's time to pair it back and steer some money towards some other parts of the market.
Stipp: And make sure when you're doing your rebalancing not to overlook overseas investments and those haven't looked as hot recently.
Benz: They haven't and certainly that you might address that as part of your rebalancing program, look at where your foreign equity exposure is versus your targets. I did an interesting article just this past week where we looked at world allocation funds and where our top rated world allocation fund managers are placing their bets these days. One thing that jumped out loud and clear is that these are managers who can go anywhere and generally speaking they were preferring foreign equities to U.S. equities right now and I think that probably is largely an outgrowth of valuation considerations.
Stipp: Okay, so valuations do look pretty full right now. Maybe expect some volatility and it seems like there are some opportunities to sort of tactically rebalance if you will.
Benz: Right.
Stipp: Another risk that probably isn't on a lot of folks minds is inflation risk because we haven't seen a lot of it especially recently with oil prices coming down, but it doesn't mean you should ignore it as you're doing a risk assessment.
Benz: That's right, inflation has been very, very low and one thing we've seen when we look at flows going in and out of funds is that investors seem to abandoning a lot of investment types that they would typically use as hedges against inflation. So, we've seen pretty strong outflows coming out of treasury inflation protected securities funds, also commodities funds, certainly performance hasn’t been great in either of these areas. Commodities especially have been affected by slumping energy prices, so investors appear to be kind of giving up on these inflation hedges and there might be some rational reasons to do so. I think the key thing that they want to keep in mind though is that the prices have become depressed as well, so is it necessarily a good time to be giving up on some of these categories if you know in the long-term, you want them to be part of your portfolio.
Stipp: Let's talk about a third big risk that you want to size up with respect to your portfolio. Somewhat related to inflation, they often go hand in hand and that’s interest rate risk, the risk that rates might go up, also assuming that we’ve been expecting but haven’t seen yet, but maybe even all the more reason to be aware of it now?
Benz: The Federal Reserve has telegraphed that it is likely to take some action on interest rates in 2015, but again as you said Jason, it is kind of a guessing game, we've seen a lot of even very high profile professional investors opine that they think that rates are on the way up and we really haven’t seen that come to pass. So I think you want to be careful about taking really drastic measures here to protect your portfolio against big interest rate increases.
We've talked to a lot of investors for example who've just taken their whole bond allocation and moved it cash and that seems like maybe a good short-term move. But a few years later we've seen a pretty good rally in bonds and that probably wasn’t a great decision. So I think investors want to avoid – should avoid those either or decisions. I do think though if you have fixed income exposure in your portfolio probably do want to avoid long-term bonds, particularly given the very strong rally that we've seen over the past year for people who have fixed income exposure. Probably short and intermediate term exposure makes more sense than venturing into long-term bonds, given how low yields are for those bonds now.
Stipp: What's a good way for me to assess what kind of exposure I do have to interest rate risk or rates going up, how can I stress-test it?
Benz: Well, we've talked about what's called a duration stress-test that was shared with us by Vanguard's Ken Volpert. What that means is that you are looking for the duration of a bond fund that you might own and you are also looking for the SEC yield, the Securities and Exchange Commission yield which is a current snapshot of the investments yield. So you are subtracting that SEC yield from duration, the amount that's left over is the rough amount that you might see that particular fund lose in a one year period in which interest rates rose by one percentage point.
It's a very rough rule of thumb, investors shouldn't expect to use it with any degree of precision, but it can get you in the right ballpark or at least get you prepared for the types of losses that you might see for various product types.
When you look at, say, a long-term bond fund today, some of them may have durations of 14, 15 years even and their yields in many cases are well under 4%, that's a 10 percentage point loss in that one-year period in which rates go up by one percentage point. That is a big rate shock, but nonetheless that would be a sizeable loss perhaps more than that bond investor would have bargained for. It's also worth noting that this duration stress-test is really only going to be helpful in so far as you are looking at high-quality bond types, it's going to be less useful for lower quality bond types that really aren't responsive to what's going on in the treasury market.
Stipp: Christine, sizing up the risk, a key part of your portfolio checkup, thanks for helping us with those tips today.
Benz: Thank you, Jason.
Stipp: For Morningstar I'm Jason Stipp. Thanks for watching.
