Market-Cap Weighting and Bubbles

Discussion of the Stock portion of the Permanent Portfolio

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bethers

Market-Cap Weighting and Bubbles

Post by bethers » Fri Aug 06, 2010 1:47 pm

Due to  market-cap weighting of broad index funds and the potential danger that develops when bubbles build (ie more exposure to over-priced stocks),  is it possible that a slice and dice method using sector ETFs would be a good risk-management strategy for the stock portion of the PP? 

Maybe market-cap weighting isn’t as much of an issue because the stock allocation of the PP is relatively low at 25%-35%?
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MediumTex
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Re: Market-Cap Weighting and Bubbles

Post by MediumTex » Fri Aug 06, 2010 1:50 pm

I see no added value in a slice and dice approach to the equity allocation, other than perhaps making a small commitment to an international index fund in addition to a U.S. equity index.
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Re: Market-Cap Weighting and Bubbles

Post by foglifter » Fri Aug 06, 2010 2:11 pm

bethers wrote: Maybe market-cap weighting isn’t as much of an issue because the stock allocation of the PP is relatively low at 25%-35%?
I guess you got it right  :D. Consider slice-n-dicing of equity part as the icing on the cake. I use US TSM as a core with some dividend-tilted small cap emerging markets exposure.

Perhaps a "cleaner" approach would be to use pure TSM for the equities part and experiment with slicing and dicing in your VP (if you have one).
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Re: Market-Cap Weighting and Bubbles

Post by craigr » Fri Aug 06, 2010 5:22 pm

Bubbles in stocks tend to build up across the entire stock market at once. The best risk-management strategy really is to keep the asset allocation rebalanced as needed. In the last major bear markets in stocks someone using the Permanent Portfolio strategy would have been selling down their stocks as the bubble grew and buying assets that were less popular at the time.

For instance, in the late 1990s they were buying gold which was at a 20 year low right before the 2000 crash. And in the 2007 timeframe you'd have been selling stocks and buying both LT bonds and gold which both did well during the 2008 crash. These moves didn't involve any speculative timing or sector plays but turned out to be profitable and avoided losses in the total portfolio even though stocks did terribly those years.

I think a market cap weighted index is the most efficient way to own stocks. It represents the combined wisdom of the markets to what prices should be for all companies. When you move away from cap weighted index you are essentially taking a bet that the market is wrong and the sectors you picked represent a more favorable outlook. This could work out to your favor, but it may not. It all depends how the future plays out and we just don't know what that will be.
Last edited by craigr on Fri Aug 06, 2010 5:28 pm, edited 1 time in total.
bethers

Re: Market-Cap Weighting and Bubbles

Post by bethers » Sat Aug 07, 2010 12:55 pm

"The best risk-management strategy really is to keep the asset allocation rebalanced as needed. In the last major bear markets in stocks someone using the Permanent Portfolio strategy would have been selling down their stocks as the bubble grew and buying assets that were less popular at the time.”?
Yep, I can see how asset allocation rebalancing can avoid a lot of grief and heartburn in the long run.
“When you move away from cap weighted index you are essentially taking a bet that the market is wrong and the sectors you picked represent a more favorable outlook.”?
As an example, Vanguard offers eleven sector ETFs which I assume as a whole represent the entire market.

When looking at the individual sectors they don’t all appear to be correlated. For example, three of the sectors (energy, health care, and information technology) are down YTD (08/06/2010).  All the other sectors are up with REITs, consumer discretionary, and industrials  doing quite well.

With sector investing it seems when it comes time to rebalance one could fine tune and zero in on the sectors that are up, possibly “seeing”? where bubbles are building and taking action without selling all equities as a whole, which would be the case with a broad-based index.

I can see that the sectors appearing not to be correlated is just a snapshot and as mentioned the bubble could build up across all sectors at the same time resulting in rebalancing/selling as a whole much like a broad-based index anyway. 
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