Nowhere to Go But Down?

How much higher can the stock market go and what to do with your money?

The question most investors' are asking these days is: How much higher can the stock market go? You have, no doubt, heard by now that this is the second-longest bull market in U.S. history, and every day new records are being set. Can the market go higher? Here’s the thing: That's not really the right question to ask. The real question is: Do you need to be in stocks versus other opportunities where you can put your money?

The thing to understand is there are two investments that fundamentally compete for money: equity and debt. Equity investments are an ownership interest in an entity and represented in the public markets by stocks. Debt investments are a lending relationship, represented by bonds. Stocks and bonds are the two places investors can put their money. Everything else is a derivative of those two asset classes. The relative attractiveness of these two asset classes can materially impact the markets and future returns. 

The easiest way to think about how these two competing investments affect each other is to first look at bonds. All values ultimately stem from the return you can get in the bond market. For example, if you could by a U.S. Treasury bond with a 10 percent guaranteed interest rate for the next 10 years, how much of your money would you invest in stocks? Well, the long-term return from stocks is 10 percent, but that potential return comes with uncertainty and the occasional crash. So if you could get 10 percent guaranteed, a rational investor would put nothing in stocks.

As that guaranteed return from bonds drops, the bonds become less attractive compared to the potential return from stocks. Thus, money starts to flow into stocks. 

That's basically what has happened throughout the last eight years. The return on guaranteed bonds has dropped to record lows. In fact, the returns are so low that they barely offset inflation. Bonds yield about 2.3 percent and inflation has been running at 1.7 percent. So, if you want to grow your wealth or live off your money, it's very difficult to do with bonds.

To give you a sense of the difference in return, for bonds yielding 2.3 percent, it would take 32 years to double your money. If stocks return 10 percent going forward, it would take seven years to double your money. If stocks return 6 percent, it would take you 12 years. If stocks return just 4 percent, it would take 18 years. Thus, even if stock market returns are meaningfully below long-term averages going forward – which they may be – they are still far more attractive than bonds, currently.

In fact, in our dividend growth portfolio, the dividend income from our stocks is about 3 percent. Compare that to the interest on a 10-Year Treasury bond of 2.3 percent. The dividends alone, not to mention any dividend growth or price appreciation, can provide a greater income return than bonds.

There are multiple reasons to continue to stay invested in stocks. We still have a meaningful allocation to bonds in our strategies, but they serve as defense to bad markets, not as a primary means of growing or living off your wealth.  That's the reality of today's markets for bonds.

While it may be tempting to just sit on the sidelines and wait for stock prices to correct, this carries risks as well.  Every year an investor sits in cash, the investor loses about 2 percent to inflation, and if retired and taking distributions of 4 percent a year, they are losing a combined 6 percent a year. Do that for a few years in a row, and you can see how cash has its own risks. 

Accepting the reality that we need stock returns to help achieve financial goals, we are not simply relying on the good graces of the stock market to deliver the returns we need. To further protect the value of your money in stocks and still pursue higher returns, we are avoiding the most speculative parts of the stock market. There are plenty of big companies that sport large market valuations, which are not supported by much in terms of earnings or dividends. 

When the market turns, those types of companies often inflict the most pain.

In addition to avoiding certain areas, we are actively managing the risks of each of the companies we own, and we invest in companies whose stock prices are closer to the intrinsic value of the underlying businesses.  Despite the stock market's generally high valuation, we are finding things to invest in that are fairly priced, and sometimes even cheap.  That's one of the advantages of investing in individual companies.

In times like this when markets feel strange, how can you achieve your goals of growing, living off and defending your money. 

Categories: Economy/Politics