Jeremy Siegel is a finance professor at the University of Pennsylvania’s Wharton School of Business. His research and book, Stocks for the Long Run, have documented investment returns and performance patterns back into the 1800s.
On a conference call with advisors October 18, he communicated his bullish thoughts.
“Relative to bonds, I’ve never seen a cheaper market,” Siegel said.
He acknowledged that the economic recovery is slow and will continue to be. He focuses, though, on earnings expectations for publicly traded companies. Even after being revised downward, expectations for 2011 earnings are still at all-time highs. Combine that with low interest rates and Siegel says, “Stocks are a buy by every principle we know in finance.”
While earnings are the most important element of stock performance, they certainly aren’t the only one. There are other positive factors as well but they are presently outweighed by investor sentiment. “Risk aversion is the only thing holding the market back,” Siegel said.
Cash flow, the contrary indicator?
Risk aversion is clear when you look at cash flow into and out of mutual funds.
More money is flowing into bond funds than did into stock funds during the euphoria of 1999-2000. This trend has significantly changed the overall mix of assets that average investors hold.
Recent work from Ned Davis Research indicates that as of the end of June 2010, bonds as a percentage of assets for households and trusts were 20.7%. The 55-year average is 13.0%. That means ownership of bonds in the average family’s mix of assets has risen 59% above the long-term average. The 13.0% long-term average has climbed slowly over the past 25 years as only three years in the past 25 have featured bond ownership less than the 13% average.
Now, here’s an interesting view from the flip side. Institutional investors (sometimes referred to as the “smart money”) have decreased their bond holdings over the same period. Public and private pension funds as of June 30, 2010 held 24.5% of their assets in bonds, down from a 55-year average of 40%.
While individual investors increased bond holdings 59%, institutional investors reduced bond exposure by 39%. It’s important to note that the bond reduction by institutions doesn’t translate directly to an increase in stock exposure. A lot of institutional money has moved to alternative assets such as natural resources, private equity, and other non-traditional investments.
Bonds still key to portfolio diversification
While we believe bonds still have a strategic role to play in almost all portfolios, the characteristics that have attracted individual investors (less fluctuation, better returns relative to stocks) are not likely to continue to the same extent forever.
New issuance of high-quality corporate bonds has produced record low income payments. Microsoft set a U.S. record in September with a 3-year bond offering paying just 0.875%. This beat IBM’s 1% bond issue in August. To receive better income returns, investors are seeking bonds with lower credit quality and higher yield.
Low bond yields also make dividend-paying stocks more attractive. With quality stocks paying attractive dividends, you may get higher income than from bonds and have the opportunity to participate in stock price appreciation essentially for free. This creates a better total return. Of course, this comes with stock market risk.
Two other primary reasons not to overload your portfolio with bonds:
- When interest rates climb from their all-time low, bond prices will decline.
- With the government flooding the marketplace with cash stimulus (and apparently more to come in November), noticeable inflation will return, eroding the purchasing power of income from low-yield bonds
We think it is best to diversify bond exposure broadly, including foreign bonds, inflation-protected bonds and floating rate bonds, all of which can be expected to fare better than U.S. government agency bonds when interest rates and inflation grow.
~ Brooks, Hughes & Jones, Partners in Wealth Management — Gary Brooks, CFP®, Allyn Hughes, CFP®, CLU, ChFC, Nancy Jones, CFP® — Tacoma, WA
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