Justifying stocks over bonds for the long haul...
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GETTING GOING
By JONATHAN CLEMENTS
Plunging In: Stocks Aren't Cheap, But They're a Better Bet Than Bonds
Stocks are ridiculously overpriced. But bonds are worse.
Make no mistake: Investment bargains are scarce. Treasury-bond yields are at their lowest level in four decades, while stocks are overvalued based on most market yardsticks.
Still, to make decent money, you need to take risks. Here's why I am inclined to take my chances in the stock market, while playing it safe in bonds.
Some experts have argued that bonds are in a bubble, comparable to the early 2000 bubble in stocks. Their fear: Interest rates will rocket higher.
That would be bad news for bond prices, which move in the opposite direction from yields. Indeed, bonds got clobbered Tuesday, with the yield on the benchmark 10-year Treasury note jumping to 3.93% from Monday's 3.72%.
But to be fair, buying bonds in 2003 isn't like buying technology stocks in 2000. Suppose you bought 10-year Treasurys on June 13, when yields hit a 45-year-low low of 3.1%. If rates climb two percentage points during the next year, your bond investment would lose just 10.7% overall, according to Vanguard Group in Malvern, Pa. Moreover, if that happened, a lot of bondholders would simply sit tight, collecting their yield and waiting until maturity to recoup their bonds' principal value.
But forget the threat from rising rates. It isn't the bond market's downside that bothers me. Rather, it's the lack of upside.
There is some slim chance we will get deflation, prompting a huge bond-market rally that allows bond investors to sell at a nifty profit. But if that doesn't come to pass, things look pretty grim.
To understand why, take the 10-year note's 3.93% yield and knock off 25% for federal income taxes and subtract two percentage points for inflation. Result: Investors are left earning less than 1% a year. That's no way to fatten a retirement nest egg.
At first blush, stocks don't appear any more enticing. According to McGraw-Hill's Standard & Poor's division, the stocks in the Standard & Poor's 500-stock index are at 36 times 2002's reported earnings and 24 times this year's expected earnings. However you slice it, stocks are expensive compared with the historical average of 15 times trailing 12-month earnings.
In fact, stocks appear to be in the same bind as bonds. With bonds, the chance of a further big decline in interest rates seems modest, while a rise in rates appears all too likely. Similarly, with stocks, an increase in the market's share-price-to-earnings multiple seems unlikely, but a big drop is a distinct possibility.
That said, there is one critical difference between stocks and bonds. If you buy 10-year Treasury notes today, you are locking in a pathetically low yield. By contrast, if you invest in stocks, you may not be purchasing a particularly large claim on corporate earnings -- but at least those earnings will rise.
Suppose corporate profits climb at, say, 6% a year over the next decade. Those rising earnings should propel share prices higher. Throw in the market's 1.6% dividend yield and stocks have a good shot at outpacing the Treasury note's 3.93% yield.
"Even if price/earnings multiples decline a lot, stocks should still significantly outperform bonds over the next 10 years," figures Andrew Engel, a senior research analyst at Leuthold Group in Minneapolis.
Stock investors also have history on their side. SEI Investments in Oaks, Pa., calculates that the stock market has gained an average 32.5% in the first year after the past 12 bear markets. The 29% rally since the October 2002 bear-market low fits right into that historical pattern.
But what if you missed the first year? How does the next year look? According to SEI, stocks climbed an average 12% in that second year.
"If investors are waiting for the market to pull back before they get in, they're being foolish," says Nancy Kimelman, SEI's chief economist. "Even top institutional investors can't time the market."
What to do? If you are currently under-weighted in stocks, I would move quickly to get back to your target percentage.
Despite my fondness for stock-index funds, however, I wouldn't buy just an S&P 500-index fund. Instead, you might combine an S&P 500 fund with index funds that give you exposure to small and foreign stocks. Small stocks have handily outpaced blue-chip shares this year. I suspect that outperformance will persist if the economy continues to recover.
Meanwhile, to avoid getting mauled by rising interest rates, look to revamp your bond portfolio. In your 401(k) plan, consider swapping out of bonds and into the stable-value fund, assuming that is one of the plan's investment options. A stable-value fund should give you a healthy yield, but without any fluctuations in share price.
What if you are investing through a taxable account? Favor short-term corporate or municipal-bond funds, which shouldn't get too badly hurt if rates rise sharply. Be warned: Many muni funds own longer-term bonds, especially those that stick with bonds from a single state. Got a fund you're interested in? Go to www.morningstar.com and make sure the fund doesn't hold bonds with more than five or six years to maturity.
"From here, you've really got to have a depression or prolonged recession for bonds to outperform stocks," reckons James Paulsen, chief investment strategist at San Francisco's Wells Capital Management. "I think there's more risk in the Treasury-bond market than in the S&P 500."
Updated July 16, 2003
KJC |
