The Globe and Mail, Report on Business
Published May 16, 2009

What do we do now?

Has the market gone too far too fast? Is it projecting too robust an economic recovery? Is it going to give back its gains as corporate earnings continue to disappoint?

Or is this the beginning of the next bull market? Did stocks overcompensate for the economic crisis? Are we starting to see the results of all the fiscal and monetary stimulation?

I've been fully invested since the fall, so I'm feeling better about things, even though I started rebalancing toward equities too soon. I arrived at this position because stocks were cheap, not because I thought the economy would recover any time soon. Based on long-term prospects, the reward/risk scenario for owning stocks made sense.

While there is no more uncertainty today than there was two months, or two years, ago, I find the current market situation to be unsettling. That's because stocks are 25 to 35 per cent less cheap than they were in March. The markets have rocketed up, while the long-term business environment is no better, and quite possibly worse - we are borrowing heavily from the future to get through the present.

I'm not alone in my unease. The current situation is just as stressful for those who are underinvested. For the most part, investors that are holding cash are doing so because of the dire economic outlook. They weren't denying stocks were cheap; they just wanted to wait for more certainty before they bought.

But their objectives haven't changed and they still need to generate a return that is considerably higher than what guaranteed investment certificates (GICs) or government bonds provide.

So what should we do at this point?

We should do what we always should do. Continually and unemotionally assess what the reward versus risk scenario is for the investments that are available to us - GICs, bonds, stocks, real estate. Then make sure the expected long-term returns are reflected in our long-term asset mix.

For example, if an investor's circumstances and objectives call for 70 per cent of her portfolio to be in stocks, and she thinks stocks will beat fixed income over the next three to five years, then her mix should reflect that. She should have at least 70 per cent of her portfolio in stocks.

For portfolios that have an alignment between valuations and long-term mix, there probably isn't a lot to do right now. Given the magnitude and speed of the rally, there may be a need for some rebalancing, but nothing more.

More action is required for those who are uncomfortably outside of their long-term asset class ranges. Investors that have their money in the bank or under the mattress have to think hard about how they're going to get to a fully invested position. Risk-free assets served them well through the crisis, but won't protect against "shovel-ready" inflation, nor will they generate the kind of returns necessary to build up a nest egg.

Another group that has work to do are investors who need to change their strategic mix. I'm referring to those who learned the hard way that they have too much risk and/or not enough liquidity in their portfolios. Extreme points in a market cycle are never a good time to make changes to a long-term target, because emotions are running high and valuations are working against you. But with a meaningful rise in the market, they now have an opportunity to start moving to a more appropriate place.

We don't know where the market goes from here. Hopefully, the current rally has shown us how difficult it is to make that call, particularly when basing it on an economic forecast. You may get the big picture right, only to find that the market is way ahead of you.

The rally has also demonstrated the benefit of sticking to a long-term plan and rebalancing, even when it feels awful to do so.

In the meantime, those of us who are driven by valuation and long-term earnings power can take solace from the words of Geoff MacDonald of Edgepoint Wealth Management.

At a presentation this week, he described their portfolios as going from "silly extreme valuations to very attractive valuations" since March 7.

So what's to be uneasy about?