For years, investors have lived with what former Federal Reserve Chairman Alan Greenspan might have called a “conundrum.”
Interest rates on money-market funds were near zero. So, savers and investors piled into longer-term bonds, driving prices up and yields way down there, too. Then they turned to conservative, dividend-paying stocks, and voilà, the same thing happened. What was left? High-flying stocks, high-yield and emerging-market bonds, real estate investment trusts (REITs), master limited partnerships (MLPs), etc.
The choice boiled down to taking more risk than you were comfortable with or settling for zero income. Investors looking for a decent balance between risk and reward had nowhere to go. They still don’t, and it’s probably even worse.
Much of this must be laid at the feet of the Fed, whose ultralow rates and massive bond buying have penalized savers and retirees while rewarding those who own stocks, bonds, and real estate — in other words, the already rich.
But most of us have to invest for retirement or our kids’ college educations, and we sure can’t change Fed policy. So, here we are with an even pricier stock market and less appealing bond returns, while so-called “alternative” investments have been a huge disaster.
Let me go through the major asset classes, and then I’ll tell you what I think your least bad choices are.
U.S. Stocks. After the election, the “Trump rally” propelled sectors like energy and financials much higher, on the promise that tax cuts, deregulation, and infrastructure building would boost the economy. That’s unlikely now — Congress may find it hard even raising the debt limit and keeping the government open — so the Trump trade ended in early March.
Instead, in a slow-growth environment I called the “Hillary Clinton market,” the FANGs ruled — Facebook FB, -0.57% , Amazon AMZN, -0.29% , Netflix NFLX, -0.45% , and Google GOOG, -0.49% , hypergrowth stocks dominating their markets. (Add Apple AAPL, -0.28% and you have the FAANGs.) They’re all up between 25% and 33%, making 2017 “the best year for the [tech] industry since…2009 and [coming] close to the heady days in 1998-99 that preceded the tech bubble bursting,” the Financial Times wrote.
Meanwhile, the S&P 500 SPX, +0.16% trades at 17.6 times projected 2017 earnings, well above the 10-year average of 14 times forward earnings. Robert Shiller’s CAPE ratio — the cyclically adjusted price-to-earnings ratio, or price divided by the average of 10 years of earnings —currently stands at around 29. The only times it was higher were in 1929 and the peak of the dot-com boom.
CAPE has been a poor predictor of market performance of late, but as my MarketWatch colleague Brett Arends wrote, recent research shows that “only when the CAPE is ‘higher than 27.6’…has the stock market proven to be a really bad investment.”
Emerging-markets stocks are cheaper, and investors have been piling in. But China dominates most publicly available funds and ETFs, and despite their attractive valuation of 12.3x projected earnings, according to Yardeni Research, I think there are many reasons to stay away.
Bonds. The 10-year Treasury TMUBMUSD10Y, +0.82% yields around 2.2%. That’s pretty feeble, which is why people are gobbling up high-yield bonds again.
But as of last week, the Bank of America-Merrill Lynch U.S. Option Adjusted Spread over 10-Year U.S. Treasuries was 3.67 percentage points, tightest since June 2014. That spread, which got as low as 2.46 percentage points in May 2007, hit its all-time high in November 2008, an astonishing 19.88 percentage points. In hindsight, that was the time to buy!
John Lonski, chief economist of Moody’s Capital Research Group, told columnist John Waggoner that “the high yield market is priced to perfection.”
The yield spread of emerging-market bonds is a mere 2.57 percentage points, the tightest since September 2007. But I’ve never understood the appeal of EM bonds, anyway.
REITs are valued about in the middle of their historic range, but they, too have had a big run. MLPs have rallied nicely since their February 2016 lows (along with energy stocks), but are well off their August 2014 peak — and both of these are niche holdings at best. How about gold or silver? Don’t make me laugh.
The best thing for investors to do now after eight years of a bull market is to put no more than 50% of your holdings in the broadest possible stock index funds, domestic and international, if you’re retired or within 10 years of retirement. Younger investors can hold more stock.
For fixed income, you can build “bond ladders” by buying several bond ETFs that mature at different dates. (I’ll have more to say about them in a future column.) And, of course, keep plenty of cash on hand when the bear arrives so you can buy stock more cheaply or not have to sell at a loss.