June 1, 2014 at 7:03 AM
The current bull market was born in March, 2009, when the Dow briefly plunged below 6500. Now in its sixth year, an aging bull means caution. The average bull market lasts just two and a half years.
Stock prices are a product of earnings and the multiple that investors are willing to pay for them. Both inputs are flashing yellow as earnings are decelerating and price to earnings ratios are stretched. Still, stocks’ big competition, fixed income, is anything but attractive. So, given something of a mixed picture on the economy, valuations and corporate earnings, where are the opportunities and pitfalls?
Equities remain the most attractive asset class. Traditional fixed income buyers have piled into riskier income-oriented investments making them generally overpriced. Among equities, domestic large caps still offer value, particularly in the financial and technology space.
Stocks: Risks Abound
Stocks are pricier now than at any time since the 1999-2000 bubble period. The Fed is tapering its bond buying and preparing to raise short term rates.
Corporate earnings growth is disappointing. While beating Q1 expectations of negative year over year profit gains, the 2.1% reported rise does not give comfort that higher than normal valuations are sensible. Fewer forecasts were upbeat than is normally the case.
Up to half of all sales by the S&P 500 are overseas. That does not give great confidence. The planet’s second largest economy, China’s, is seeing rapidly decelerating growth. Japan and Europe are pursuing the Bernanke playbook of massive monetary stimulus to jumpstart growth.
Stocks Still Trump Bonds Longer Term
Despite the risks, we maintain a constructive outlook on equities. It all comes down to the question, if not stocks then what? We believe stocks are still the best asset class.
With ten year Treasury bond is yielding just 2.45%, longer term investors can’t meet their goals by hiding in that haven for long. The earnings yield on stocks, the inverse of the price to earnings ratio, hovers currently around 6%. That pick up in return remains compelling, and would be even more so should there be any pull back.
Opportunity: Financial Stocks
In this environment, the classic strategy makes sense: Target stocks of companies that dominate their industries and pay growing dividends. To avoid overpaying, focus on less expensive and out of favor sectors.
Financials have not yet recovered from the 2008 downturn. The good news is that this has left them with bargain valuations, in many cases below liquidation value.
Opportunity: Large Cap Tech Offers Compelling Risk/Reward Tradeoff
Growth and momentum stock investors have shunned large cap tech, flocking instead to narrow hyper growth tech niches focused on social media, the cloud, or mobile. Value investors have yet to fully embrace large cap tech, concerned about sustainability of cash flows in a rapidly changing environment.
Further, while large cap tech has traditionally reinvested its prodigious cash flows, in an effort to placate shareholders these companies have been initiating and hiking dividends, plus buying back stock.
Potential Peril: High Yield Bonds
This asset class is a misnomer. The latest yield on Merrill Lynch’s “High Yield 100” index is just 4.54%, only 2.09% above the 10 year Treasury.
Junk bonds do a poor job diversifying equity risk, as they tend to move with stocks. This is unlike high quality bonds, which tend to zig when equities zag. For example, when stocks dropped 37% in 2008, junk bonds plunged 26%, but the high quality Barclay’s Aggregate bond index advanced 5.2%.
Bottom line: Junk bonds have two ways to lose now. Interest rates can move higher or the economy deteriorates and defaults grow. The current paltry rates don’t offer enough compensation for those risks.
The low hanging fruit has been picked from the stock market. With continued low interest rates, areas of the market offering solid fundamentals but still cheap prices continue to make sense. Stay clear of credit challenged bonds as there’s just not enough of cushion to offset the risks.
Note: David G. Dietze, JD, CFA, CFP™ is President and Chief Investment Strategist of Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Avenue, Summit. CNBC has named Point View number 5 on its list of the top 100 American fee-only wealth managers. See http://www.cnbc.com/id/101619698 The full-length version of this article is available at: www.ptview.com.