Portfolio Rebalancing And Valuations. Two Risks We Are Watching.

While analysts are currently very optimistic about the market, the combined risk of high valuations and the need to rebalance portfolios in the short term may pose an unanticipated threat. This is particularly the case given the current high degree of speculation and leverage in the market. It is fascinating how quickly people forget the painful beating of taking on excess risk and revert to the same thesis of why “this time is different.” For example, I recently posted on “X,” which showed a visual of the 2021 market surge versus 2023-2024. While this time is may be different, don’t be surprised if it ends the same.

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One of the near-term risks to more bullish investors is the combination of high stock valuations and the necessity of portfolio rebalancing, which could impact market stability. Using 2023 data, it is estimated that mutual funds in the United States held approximately $19.6 trillion in assets, while exchange-traded funds (ETFs) managed about $8.1 trillion, suggesting a substantial number of portfolios containing combinations of stocks and bonds.

With the year-end approaching, portfolio managers need to rebalance their holdings due to tax considerations, distributions, and annual reporting. For example, as of this writing, the S&P 500 is currently up about 28% year-to-date, while investment-grade bonds (as measured by iShares US Aggregate Bond ETF (AGG), are up 3.2%. That differential in performance would cause a 60/40 stock/bond allocation to shift to a 65/35 allocation. To rebalance that portfolio back to 60/40, portfolio managers will need to reduce equity exposure by 5% and increase bond exposure by 5%.

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Depending on the magnitude of the rebalancing process, it could exert downward pressure on risk assets, leading to a short-term market correction or consolidation.

The stock-to-bond ratio also demonstrates that risk.

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