HIGHLIGHTS: Wednesday, March 2 2016
Many times I am asked how much money should be invested in a specific stock or area of the market? The answer is not as simple as 5% , 10% or 100%, I wish it would be, but it is not. It also is not complicated either. In these writings you see me talk about fair value of stocks, sectors and the market in general. These weightings or relative values can give you an excellent starting point in determining how much money should be placed in the various places.
In yesterdays report you saw the most current relative/fair values of the ten sectors within the domestic market. In that table, Health Care was under fair value and it remains so today by 3.4 percentage points. The current valuation for the sector is 86.6%FV. The probability is currently higher that the sector will eventually move up to fair value at 100.0%FV. On the other side of the equation is Utilities, which is over fair value by 2.4 percentage points at 102.4%FV. In this case, the probability is higher that this sector will eventually move down to fair value. In this simple two sector example we have one that has a higher probability to move up to fair value, Health Care and a second that has a higher probability to move down to fair value, Utilities. An investor might quickly decide to put all of their money in Health Care and sell Utilities. Unfortunately, the market works on probabilities of out- comes and not absolutes. This is why we adjust the allocation between markets, sectors and stocks and not enter arbitrary, all-or-nothing, BUY/SELL positions. We also make ad- justments over time rather than all at once because markets do not move in a straight line. A possible adjustment for consideration would be to increase our allocation to Health Care and reduce our allocation to Utilities. By how much?
The capitalization weighting of the market is currently 14.8% Health Care and 3.4% Utilities. If we take the fair valuation weightings for these sectors we would have 15.5% in Health Care and 2.6% in Utilities. This results in slightly more in Health Care (0.70) because of the probability it will increase and slightly less in Utilities (-0.87) because of the probability it will decrease. We make the adjustment according to how much the sector is over or under weight from fair value.
These adjustments occur gradually over time and do not have to be perfectly aligned. They simply provide a guide as to where the market is above or below fair values and where opportunities may exist. It is something to consider when making al- locations within a portfolio or answering the question, how much?