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Stock Strategist
7 investment rules for a low-return world
With the prospect of 20 years of real returns under 2%, investors can't rely on their old standbys. The richly priced U.S. stock market means you'll have to look elsewhere.
By Curt Morrison, Morningstar
In a Stock Strategist column I wrote last month, I argued that the S&P 500 Index ($INX) is currently priced to provide a long-term total real return of approximately 2%. Although this is less than one-third of the index's historical average, the result might be even worse during the next two decades.
On three occasions in the 20th century when the market sold at valuations similar to the current level, the subsequent 20-year real return fell short of 2%. In response, many readers wrote to ask how they should structure their investments.
The answer is different for each investor because it is affected by his or her skills, special needs and investment horizon. At Morningstar, we can't offer advice tailored to an individual, but I'll present ideas here that might be helpful to a broad swath of investors.
Don't worry too much about indexes
If you are an astute judge of business value with less than $10 million to invest, the prospective return of the broad market doesn't concern you very much. You can still find individual stocks that are attractively priced. It might be harder to find them, but they are out there.
Small investors have an advantage over institutions with billions of dollars in capital to deploy. Many small-cap stocks aren't sufficiently liquid to satisfy pension funds and university endowments. Your investment universe is broader than theirs, and that should work to your advantage.
Don't be afraid to hold cash
The real return on cash is negative right now, so it can't be considered a way to store value. However, the stock market is volatile. If you investigate many companies and exhibit patience, eventually Mr. Market will provide you with the opportunity to buy undervalued businesses. It's smarter to hold cash than to purchase overpriced stocks.
Become a citizen of the world
U.S. stocks comprise only 50% of the world's market capitalization. Unless they are undervalued, domestic equities shouldn't be overweighted in a portfolio. To the contrary, there is some evidence that suggests foreign stocks as a group offer better value now, so investors should garner superior returns by focusing on foreign equities.
Also, many overseas markets appear to be less efficient than the U.S. market. This means that there is a greater benefit from active management. There are a number of excellent mutual funds that invest abroad. Some of my favorites are Dodge & Cox International Stock (DODFX), Matthews Pacific Tiger (MAPTX) and Third Avenue International Value (TAVIX).
Take a look at TIPS
Treasury Inflation-Protected Securities (TIPS) offer roughly the same real return as the S&P 500 Index, but their value is likely to be much less volatile. I think the natural real interest rate is between 2% and 3%. Given that, TIPS are selling near fair value today. They aren't a bargain, but relative to the broad stock market, they look very attractive. You can buy these bonds directly from the government, or you can invest through a mutual fund such as Vanguard Inflation-Protected Securities (VIPSX).
Be careful with bonds
Conventional bonds (those without inflation links) promise payment in nominal dollars. However, I'm not sure if we'll experience inflation or deflation, or to what degree either will occur. Without that knowledge, it's impossible to assign a fair value to a long-term conventional bond.
Investors got more inflation than they expected between 1940 and 1979, and the real return on long-term government bonds was a loss of 1.8% during that period. Few analysts expect deflation at this point, but if it occurs, then the value of government bonds will rise. Bonds might play an important role in your portfolio, but before you invest, make sure you understand the relationships between inflation, deflation and bond values.
Consider commodities
There are reasons to think that commodities are in the early stages of a long bull market, but you needn't believe any of them to want to invest in this asset class. Commodities have demonstrated low correlation with other asset classes in the past, and they might perform well even if stocks, bonds and the dollar do poorly. You can get exposure to commodities through PIMCO Commodity RealReturn Strategy (PCRDX).
Defend against a falling dollar
Protect yourself against the possibility of a meaningful depreciation of the U.S. dollar. There are plenty of reasons to believe the dollar will fall in value and reduce your purchasing power. It's therefore prudent to hold at least a portion of your foreign stock and bond investments in funds that don't hedge their currency exposure.
Dodge & Cox International Stock does not hedge its exposure. Third Avenue International Value does employ some hedges. American Century International Bond (BEGBX) contains high-quality foreign bonds with relatively short maturities and no currency hedges, so its value tends to rise with a falling dollar (and vice versa). Also, a depreciating dollar is likely to benefit investors in commodities.
In late 2004, stocks are expensive, bond yields are low and the ratio of residential real estate prices to income or rental rates is near multigenerational highs. These rich valuations imply lower future returns. In this environment, I think investors should pay extra attention to capital preservation. In other words, be careful out there.
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