Of course not. Earnings are up less than 5% over the last year, and revenues even shy of that, so stocks’ last 12 months near 30% gain far outstrips the actual growth of corporate earnings, thus pushing valuations to their highest since 2008.
Unemployment remains stubbornly high, and would be much worse if so many Americans hadn’t just given up and stopped looking, leading to the lowest labor participation rates since 1978.
Fiscal policy? Narrowly averting a default on our debt, and enduring a near two week shutdown, our Government kicked, no, nudged, the can down the road. Budget negotiations start up again in January, with the debt cap struggles slated for February. Certainly not an inspiring backdrop for stocks.
Monetary policy? Pick your month, but tapering is coming, meaning reduction in the Federal Reserve’s policy of bond buying to support the economy and the housing market. Meanwhile, there are actually investment strategists who urge to you jump in the equity pool because they predict tapering will come in March, not December! Hardly the epitome of long term thinking.
Most areas of the market are not bubbling – the overall price to earnings ratio, while the highest in nearly five years, is not over 20 as was seen in the dot com craze of the late ‘90s. As Warren Buffett said the other day, stock prices are in a “zone of reasonableness”.
Investors must stay the course. As hard as it is tell the newly minted retiree to invest his cash, it’s also hard to tell the nation’s endowments and other institutional pools of money to go to cash – not when there’s a need to distribute some 4 to 5% annually from those funds, and cash and high quality fixed income are yielding far less.
Strategies to pursue now including rebalancing to reduce risk, diversifying your portfolio to include overseas investments, controlling one of the few things you can – your taxes, and avoiding market cap oriented indexing.
Don’t Drift – Rebalance
We all profess a desire to buy low and sell high. However, it’s awful hard to sell “what’s been working” and redeploy into what’s been a disappointment.
This is a year that’s ripe for rebalancing. If you began in January with a classic 50/50 stock/fixed income allocation, and your investments tracked the indices, so your stocks are up 27% and bonds down nearly 2%, you’d now have over 56% in equities. Rebalancing dictates you shift 6% into fixed income.
That’ll definitely reduce your risk. If stocks tank you’ll have less exposure. And if there is a significant pullback, you’ll have some dry powder to put to work.
Avoid Home Country Bias
The United States is but thirty percent of the world’s stocks, yet most Americans have little overseas equity exposure. It’s understandable – we are most comfortable with the familiar. But, it may be quite costly, in terms of potential returns.
Large swaths of overseas securities are far cheaper than our markets. Across the pond, European stocks are trading at just 13.7 times the next 12 months earnings versus 15.1 for our stocks.
If you are afraid of (market) heights you can also take comfort that European stocks have not yet hit all-time highs since the ’08 downturn, unlike our own markets. Finally, the European monetary authorities just reduced benchmark interest rates; investors in Euro stocks don’t have to worry about any tapering by the Continent’s central bank.
Emerging market stocks (EMS) look quite attractive, too. Over the last three years domestic stocks have averaged a 14.4% annual return, but the EMS are actually down 3.3% annually, resulting in domestic stocks being 57% more expensive than the EMS.
Among EMS, Korea looks interesting. Its market is down 2% this year, resulting in its stocks trading at less than 9 times earnings. But, expected growth far outstrips our outlook; next year Korean corporate earnings are expected to climb over 14%, and in 2015 expect growth to top 19%. Its companies, like Samsung and Hyundai, are making steep inroads into our economy.
Control What You Can – Like Taxes!
Since 1926, stocks and bonds have returned 9.8% and 5.4%, respectively, but adjusted for inflation those numbers fall to 6.7% and 2.3%. When you further reduce for taxes, you’re left with just 4.5% and 0.6%. You can’t will future returns, nor can you do much about inflation. But you can minimize the tax bite, and keep at bay that second deduct from your returns.
How? Locate your investments in the most tax efficient accounts. Stocks don’t produce much ordinary income, and thus belong in taxable accounts, while your bonds, REITs, and other investments that generate ordinary income are best held in your tax sheltered accounts, like IRAs and 401Ks.
But, that’s just the first step. While taxes should never be the primary driver of portfolio management, by carefully offsetting any capital gains with capital losses you can reduce any net taxable capital gains, so as to pay less taxes.
To provide yourself with these tax savings options and keep better control, prefer an unbundled portfolio of stocks in your taxable account versus mutual funds. Direct holdings of stocks allow you to establish your own tax basis, and avoid inheriting a fund’s tax basis in its stocks, which is typically much lower since it was established well before you joined the fund. Funds also reduce control over your taxes since the funds, not you, decide when capital gains and losses will be realized.
Avoid Market Cap Indexing
Indexing via a market cap weighted index, like the S&P 500, sounds good, but over the long haul you may leave significant profits on the table. That’s because in market cap weighting, the more expensive the stock, the greater the emphasis, while the cheaper the stock, the lesser the weighting. That’s counter intuitive to most investing, which seeks to deemphasize in a portfolio the more expensive and the overpriced, while rotating into the less expensive, the bargains.
An alternative is to weight each stock equally, buying 0.2% of each of the 500 stocks. While you’ll still have some exposure to the “mistakes” in the index, you’ll reduce your exposure and risk to any one stock because of the smaller weighting.
It’s been shown that this equal weighted approach outperformed the market approach by about 2% annually over the last 40 years, before trading costs. That’s too much to leave on the table.
We urge investors to avoid funds, index or otherwise. Use individual stocks to accentuate the less expensive equities, the bargains, and exit or reduce exposure to the overvalued, the more expensive. Keep trading to a minimum to avoid costs, plus look for opportunities to reduce taxes by offsetting any realized capital gains.
David G. Dietze, JD, CFA, CFP™ is the founder, president and chief investment strategist of Point View Wealth Management Inc.