Market Musings Blog

The stock market has been flirting with five year highs – but not breaking through to all time highs – for a  week now. We are at an inflection point in the markets, for both stocks and bonds, and the coming days should tell us whether we will finally reach escape velocity and surge to all time highs on the Dow and the S&P, or whether it’s back down to the trenches for who-knows-how-long. 

The strongest argument for new highs and a new bull market is valuation. The PE on stocks is low. Depending on how you measure it, it’s around 13 give or take. The last two times we’ve been near these levels on the S&P, the PE was 26 and 15 (2000 and 2007, respectively). Twenty six was ridiculously high and 15 was not enough to produce escape velocity, apparently – because we didn’t. Implied returns from a PE of 13 are around 13% per year over the next five years – certainly better than most bonds. The average PE after a recession-recovery cycle is 13.9 – higher than where we are now. So from a valuation perspective, it should happen. We should reach new highs and head to orbit.

But assets can stay cheap for what seems like forever. The intrusion of government into the private economy, troubles overseas, and countless other “products of the milieu” are very worrisome and have convinced many investors to sit on the sidelines. 

Hold your breath, because this battle between the bulls and the bears is about to be decided. A win by bulls will have us off to the races, and stock investors will be very happy indeed. A win by the bears consigns us to another long hibernation.

Occasionally, and always when things are going well, a client will ask us for a riskier portfolio, which usually means we are supposed to sell those good-for-nothing bonds and add more stocks. In other words, “risk up.”

Our industry has done a disservice to investors by oft-repeating this phrase: “The more risk you take, the more return you’ll earn.” Sometimes this is flipped, as in: “To obtain a high return, you must take more risk.” After years of this mantra, we can’t blame investors for reacting to good returns by wanting more “risk”. And note that these sentences are constructed to appeal to every human’s inclination towards greed: who wouldn’t want more return?

The problem is, these shorthand phrases are akin to incomplete sentences. Technically they qualify as complete sentences, but in fact they leave off the most important concept around risk, the thing about risk that will make you cry, feel despair, and swear off stocks forever and this time I mean it: risk means big losses as well as big returns.

On your way to earning 90%, your risky portfolio will hand you months, even years, of misery. That’s “will”, not “may” or “might”. You will have losses. If you put $100,000 into an S&P index fund on 1/1/08, it was worth $63,000 by the end of that year. It took until sometime last year to get back to even – nearly four years underwater. Furthermore, if you react by selling because you just can’t stand it any longer, you will effectively decimate your returns for years to come. The lack of money in your portfolio will only reinforce your misery.

On the other hand, if you truly have the temperament for it, a risky portfolio will eventually hand you more return than non risky portfolio. Eventually.

Here is how to know if you are a candidate for a riskier portfolio than you have now, assuming you’re not already way out in the risk stratosphere:

• When stocks go down a lot, you get excited. You can prove this because in 2008/9, you added to your stock portfolio and/or you did not stop your 401(k) contributions to stock funds.
• On the other hand, when stocks go up a lot, you worry.
• You think about your portfolio as a whole, and losses on this or that individual holding do not bother you. You do not obsess about making back losses.
• You are willing to increase your investment time horizon. In other words, if you were investing for the next ten years, you can take on more risk if you recognize that you must think now in terms of investing for the next fifteen years. You may need those extra years to recover from losses.
• You inherited a bunch of money/invented something really cool/found oil in your back yard and do not need to live off your portfolio any longer.
• When the news about the economy/politics/environment is bad, you understand that this, too, shall pass. You can insulate your investment decisions from how you feel about the news.

If the majority of these things are not true of you and your investment behavior, better think long and hard about “risking up”. Even if you can identify with most of these descriptions, be careful: timing counts. With stocks bumping up near highs, now may not be the best time to increase portfolio risk.

In one corner, we have a company that owns commercial real estate. It owns properties located all over the country, mostly stand-alone buildings with one or two tenants, many of them leased to banks. This company was thoroughly sideswiped in the recession. It was forced to pay its dividend in stock rather than cash for a while. Revenues have slipped nearly every year since the recession of ’08. Cash flows have not yet recovered, but have at least stabilized. On the other hand, things are improving. Revenues aren’t falling as fast; occupancy is ticking up. The dividend yield is 5.6% and it’s now paid in cash. The stock sells at a measly $10.75.

In the other corner, we have Apple, a corporate powerhouse. Rich in cash, with huge and consistent sales and earnings growth, and a brand new shiny dividend, instituted in mid 2012 (Apple did pay a dividend back in the ’90s, but it was eliminated when the company nearly went under.) With the right mix of hardware and software, Apple has captured hearts all over America, resulting in long lines outside its retail stores when new products are launched, and a stock price in the stratosphere, at over $500 per share.

Which stock has done best over the last year?

The first stock, Lexington Realty, has outperformed Apple’s stock by about eighteen percentage points. LXP is up 32% over the last year, while Apple is up 14%. That doesn’t include the hefty dividend on LXP.

But that’s a cheat, you say. It’s easy to find a low-dollar stock that’s done well in this market. Ok, what about a mundane industrial stock, like Illinois Tool Works? ITW makes everything from fasteners and solder to putty. It has been around since 1912 and has never been thought of as glamorous. It has edged Apple out of the ring by rising just shy of 20% over the last year. It sells at $61.87 today.

The more interesting fact is that if we run longer historical numbers, Lexington outperformed Apple from about 1994 through early 2005 when finally Apple pulled ahead. ITW bested Apple from about mid 1987 through early 2008; then Apple surged. Fact is, the wondrous performance by Apple has been recent, boisterous, and incomparable to any other time in the company’s history.

We’re not here to bash Apple. Our point is only that performance need not come from the most popular companies on the planet. It can come from overlooked stocks that make necessary items (no, the iPod is not a “necessary item”) or own useful assets. And sometimes, the performance from these boring stocks comes with much less drama to boot.

Today the S&P 500 closed at a five year high. In fact, it’s within shouting distance of an all time high. Another roughly 7% appreciation, and the stock market will once again reach an all time high. (The highest closing price of the S&P was 1565.15 on October 9, 2007; there was an intraday high hit on October 11, 2007 at 1576.09.)

About time, we say. We’ve waited for years for stocks to gain some traction and a new all time high would help immensely. Not that the last few years haven’t been profitable, but viewed point to point from the late 1990s to now, stocks haven’t done much for the buy-and-hold investor.

We think the chances of further progress in 2013 are pleasingly high. The biggest impetus for prices is the intensely negative sentiment that has infected the stock market for years now. The media are full of reports of investors selling out, dropping stocks from portfolios entirely, and swapping to bonds. So far, that’s worked. But this year, chances are it won’t. In fact, government bond investors may have losses. What the stock market really needs is the tables to turn: big gains on stocks versus losses on bonds will convince investors to shift the other way, towards stocks instead. When that happens, we could be in for a multi-year long term bull market.

Meanwhile, there is nothing on the horizon that indicates that fundamentals are worsening for stock investors. In fact, improvement is all around us – in earnings, debt reduction, progress on the “cliff” talks, employment, housing, even manufacturing. Investors should not confuse personal judgments about the direction of politics with the possibilities for investments. You may detest Congress, abhor regulations and tax increases, believe for all you’re worth that the country is headed in the wrong direction, but in the end, the market is judging that circumstances are not worsening. Incremental improvement is everywhere. And that’s what matters.

Just a note to update our post regarding IRA catch up contributions available to those over 50 years of age for 2013:

Updated IRS regs show you may still make a $1000 additional catch up contribution to your traditional or Roth IRA for 2013, which is in addition to your regular $5500 contribution amount. The 2013 catch up contribution for employer sponsored accounts such as 401(k)’s is $5500, which is in addition to the regular $17,500 contribution amount.

Happy saving!