by Charles N. Waterhouse, Vice President, Senior Financial Advisor
“I've been rich and I've been poor. Believe me, rich is better.”
- Sophie Tucker
Stock Market Rally
I’ve been in Bull Markets and I’ve been in Bear Markets. Believe me, Bull Markets are better!
Four years ago this month, one of the worst bear markets in our generation ended with a thud. On March 9th, 2009, the Dow Jones Industrial Average hit rock bottom at 6547. It is a time etched in the psyche of many investors. But since that day, we’ve had a four year ride that has gone mainly one direction: up!
This bull market ride took the Dow to a new all-time high this month, breaking through the previous high of 14,165 set on 10/7/2007. The rally continued, putting together a string of new highs as investors bought in so they wouldn’t be left behind. While there may be some consolidation pullback, it appears that this rally has legs.
Both corporate profits and valuations have supported the recent run up in stock prices and may provide the underpinnings for further gains. Valuations on U.S. stocks have moved from 12 times earnings in September 2011 to 15 times earnings today. But that’s still less than the historical average since 1955 of 16.8 times. With consensus S&P 500 earnings per share forecasts for 2013 of $107, a move in valuations to the historical median would support another 15% increase in stock prices. No guarantees that that will happen, but it does appear to support further upside potential for the stock market.
Bond Market Outlook
With short-term interest rates at record lows, investors have been searching for more yield and worrying about what will happen when interest rates start to rise. Our internal Investment Committee has been exploring the same issues. In our most recent semi-annual Investment Offsite session, our agenda was dedicated to enhancing returns in the current low rate environment, while protecting clients’ portfolios in a rising rate environment.
To understand this issue a little better, let’s break it down. First, let’s look at the broad bond market, as represented by the Barclay’s Capital Aggregate Bond Index. It has a current yield around 2% and a duration (think average maturity) of about 5 years. (Duration is defined as the sensitivity of the price of a bond to a change in interest rates.) As interest rates increase, the price of bonds decreases based on duration. With a duration of 5 years, the broad bond market will decline in value by 5% with a 1% increase in interest rates. To take that one step further, we can look at the bond’s total return. Starting with a 2% yield, if we get a 5% decline in value, we end up with a total return of -3%.
Let’s look at another investment option: high yield bonds. While these types of bonds add more credit risk to one’s portfolio, there can be some benefits as well. Consider that the class currently yields about 7% and has a duration of about 4 years. So if interest rates increase by 1%, their value falls by 4%. If you’re starting with a 7% yield, your total return is still positive at 3%.
We felt it was important to develop a strategy that not only addresses the current low rate environment and the effect on total return, but also helps protect our clients’ portfolios from the effects of rising interest rates. Our strategy involves continuing to add current return by utilizing exposures to sectors like high yield bonds, preferred stocks, Real Estate Investment Trusts (or REITs), and Master Limited Partnerships. We are also adding exposures to two unconstrained/multi-sector bond funds, that can quickly adjust its exposure from high return sectors to very short duration exposure.
When interest rates start to rise, we’ll move from the longer duration, higher risk exposures to shorter duration investments for protection as interest rates rise. Based on our current outlook, we have some time before interest rates start moving north, and when they do, it will likely be at a very measured pace. But we’ll be ready to implement the strategy’s second phase when they do.
Until that happens, enjoy the current ride in the stock market!