Wealth Clarity Blog

With stocks coming off their worst decade ever and the risk of recession rising, I’ve had many people ask me if it’s time to abandon stocks.  While this feels like the right thing to do, don’t do it!  Why? The greatest risk most people face is outliving their assets, and stocks combat this better than any other asset class.  I’ve found in times like these, it’s easy for investors to forget about purchasing power risk and focus entirely on today’s headline, as if they had the time horizon of a fruit fly.

Taking inflation into account, the real return on “safe” assets like bonds and cash is negative at today’s rates.  Since bond yields can’t go much lower, the only major move from here is up.   This means that in addition to earning a negative real rate (including inflation), you also risk losing principal on the “safe” part of your portfolio.   Alternatively, stocks are achieving an earnings yield over 8%, which is about 6% more than 10-Year Treasuries.  This, combined with strong balance sheets, high cash positions, and low valuations makes stocks fairly appealing despite all the economic uncertainties. 

Unfortunately, the price to be paid for this level of earnings yield is gut-wrenching volatility.  Hard as this is to stomach, this isn’t as bad as it seems.  If you are allocated properly for your goals and time horizon, you shouldn’t have to sell much at the bottom.  For example, a balanced portfolio would likely yield 2.5% today.   Sustainable portfolio withdrawal rates range from 3% to 5%, depending on an individual’s age.  As long as annual withdrawals are in this range, the most that would need to be sold in a given year is 2.5% of the starting portfolio value.  

I think another reason stocks are important is our changing world.  With the rise of the emerging markets, millions of consumers are entering the middle class each year.  As they earn more, they buy cars, houses, furnishings, appliances, and expand their diet.  This increases the demand on natural resources, which will likely push prices ever higher.  Companies adapt and take advantage of these changes in ways the consumer cannot.  For example, they sell to all these new customers to get increasing revenues and profits, and can raise prices if necessary.  If you own their stocks, this benefit flows through to you.

Over the years, I’ve seen many people make the mistake of thinking they can move to the sidelines until there’s more certainty.  For sure, this is sometimes a good idea.  Unfortunately, I usually see people make emotional decisions to sell stocks after they have already fallen.  Then, they sit out until all is well with the world only to pay much higher prices when they buy back in.  This is why studies by Dalbar Inc. continually show that the average investor vastly underperforms the market due to bad timing.

In the end, balance is essential.  Approaches suggesting “all stocks” or “all bonds” are too extreme for most situations.  Wealth preservation certainly calls for a healthy amount of bonds no matter how low yields go.  Investors should also hold other asset classes such as cash, natural resources, real estate, and hedge funds.   Further, valuations and the economic environment should be monitored to determine if adjustments are prudent.

I think the Wall Street adage “the hard trade is the right trade” is worth keeping in mind especially when emotions are high.  At the moment, holding stocks amidst all the uncertainty is the “hard trade.”  With earnings yields high and fixed income yielding so little, and long-term inflation risks stemming from a changing world, maintaining a meaningful allocation to stocks is the “right trade” today.

Our recent investment snapshot posed this question: “Is the current economic crisis a ‘soft patch’ or the beginning of a double-dip recession?”  I’m starting to wonder if we aren’t instead in a mud puddle.  I recently heard this term used to describe the space between soft patch and recession, and it resonated with me.

In short, our economic outlook is messy – muddy, in fact.  Yesterday’s stock market response showed some of the pent-up concern and frustration with our political circus, our persistently stuck unemployment, and the slow (or absent) economic growth that is lingering like a fog over any sense of confidence.

Is this “Groundhog Day” as it relates to the recessionary period starting in 2008?  Are we heading back towards a repeat of that time frame?  I really don’t think so, primarily because the backdrop is different this time around.  The consumer has taken steps to deleverage and in fact is saving more; businesses have gotten leaner and are generating decent levels of cash flow; and economic indicators including auto sales, home starts, and unemployment are already hovering near their lows.  It doesn’t mean they won’t move lower, but our economic dashboard is already anemic and that isn’t news.  (One important caveat: the European debt crisis could continue to have material global effects.)

Objectively, equity valuations are below historical averages on a price to earnings basis, and the earnings yield (inverse of the P/E ratio) is trending well above 10-year Treasury rates.  This is something even Warren Buffett likes to see!  When compared to other investment alternatives, including negative real rates of return on money market funds, growth assets should not be arbitrarily put in the dog house.

I have found that one healthy way to look at your portfolio is to use the following exercise:  assume that your portfolio is sitting in cash today instead of the current positions you may hold.  Then, look at all of your possible investment alternatives from a risk and return standpoint and ask yourself how you would you allocate the money if you had to right now.  Many times investors can get anchored to their existing holdings too strongly, especially when viewed through the lens of trading costs, unrealized gains/losses, and taxes.  If you try to position your portfolio using the approach above, you can minimize the emotional challenges of making investment decisions.

So, here are a few investment keys for working through this financial mud puddle while keeping you moving towards your goals:

1.  Focus on fundamentals more than you focus on the news—now is the time to hone in on the facts and not get blown around by the ever increasing list of “experts” espousing fear (in most cases.)

2.  Stay agnostic about the investment choices you have—remember that interest rates are at historically low levels, and cash is paying virtually nothing.  This isn’t the case in equities, nor in a few other spaces.  I’m not suggesting increasing your risk posture without great consideration – instead, focus on objectively seeking value where it exists.

3.  Don’t change your investment philosophy or strategy now—my experience has shown that successful investors hold tighter to their investment approach during times of uncertainty.  Better to have an approach and philosophy that you believe in (even if it’s not perfect) than to not have one at all, because the damage caused can be material.

4.  Be nimble—the world changes quickly, and the pace of change continues to increase. Make sure that your investment approach has the ability to make tactical shifts as new information emerges.

5.  Favor quality and cash flow in this potentially low growth environment—going forward, as noted in previous posts about the “New Normal,” adjusting your return expectations downward and looking at cash flow as an important part of return will be critical.  Don’t get seduced into reaching for yield or outsized returns.

How can you work through these types of world stress points?  Be resilient.  Be a survivor, and not a hero. Feel free to contact me if there is a specific question you would like me to address.