April Fools?

April 3, 2010

Are investors who buy stocks now April fools? Stocks are definitely more expensive than they were during the financial panic, but they're cheaper than they were right before it started, back when the Dow tipped the scales at 14,000.

Of course, experts don't agree on this issue. Most believe the economy will remain in slow mode for five to ten years (although they didn't feel that way back at Dow 14,000 when everything looked rosy). Those not in the slow-and-low camp are forecasting some version of a double-dip, and not the fun kind you get from Dairy Queen. Almost no one forecasts a 1990s-like decade, with a strong dollar, fast-growing economy, and low unemployment. Of course, that makes us want to err on the side of optimism. But we’re not going to be contrarian just to snub Wall Street, at least not on this call.

Bill Gross, the famed bond fund manager of one of our portfolio holdings, Harbor Bond (HABDX), expects stocks and bonds to have low returns over the next decade, around 4% or so (which he, of course, expects to beat with expert management). He's advising investors to lower their expectations. 

But then, Bill once called for Dow 5,000, which looked like a pretty bad call when the Dow rose to 14,000, but started looking pretty good again after we plunged below 7,000. 

Bill’s company, PIMCO, primarily manages bonds. It's going to be difficult to near-impossible to earn more than 4% in bonds over the next decade. That's because most safe bonds with less than a ten-year maturity yield less than 4% today, and shorter-term bonds yield less than 2%. 

But will stocks perform as poorly? Bill has an incentive to put stocks down since he admits bonds have limited return potential from here. As readers of his monthly commentary already know, Bill’s one of the straightest-shooting big investors, but he’s not going to say that stocks are good for 8% a year, and bonds only 4%. <i>He’s not</i> that straight a shooter. Not if he wants PIMCO Total Return fund to remain the world’s largest mutual fund.

John Bogle, when he’s not chiming in on the futility of active management or the outrage of non-Vanguard fee levels, tells financial TV viewers he expects lower returns than in the past, but perhaps 8% a year on the stock index.

Eight percent is not going to happen without a step up in inflation. If stocks had 8% yearly returns into the indefinite future, and inflation stayed the same, we'd have perhaps the greatest bull market in history, with even more wealth creation than the market from the post-depression period on, because 1) adjusting for today’s inflation, 8% is a great return, and 2) there is so much more money in the markets today that such a rising tide would lift all boats (the ones that weren’t traded up for yachts).

We expect a 6% approximate yearly return, derived from the roughly 2% dividend yield on stocks (adjusting for some recent cuts that may go up soon), a 2% rate of inflation on average, and a 2% increase in the value of companies as they earn more that can’t be written off as just inflation and which may partially come from share buyback programs. This does not bode well for those in variable annuities charging 2-3% per year in annual fees.

This 6% return is our expectation for US stocks. In general, foreign stocks should underperform by at least one percentage point per year over the next decade. Too much money has gone into foreign funds relative to domestic funds to keep the outperformance up for another decade.

If fund investors tended to be right, the next decade would see commodities and emerging markets beat the US market again. Fat chance. The current rally in these winners from the last decade should be short lived, and mostly reflects how hard they were hit during the financial panic . 

On the plus side, we expect some wide swings along the way that could, especially coupled with our focus on out-of-favor areas and, remaining mindful of fund fees, put us into the 7-8% range on the stock side of our portfolios. Worst case for us would be a fast move up to Dow 15,000 followed by a ten-year stall — because we’d never get a chance to buy during periods of weakness. We’re placing the "permanently high plateau" scenario at a low probability. We’d prefer a permanently low plateau world, because at least then we’d be earning maybe 4% in dividends as stocks did nothing.

The problem with investing remains the fact that there is too much money in the world chasing too few good investments. We thought this recent plunge was going to destroy enough wealth to keep asset prices at reasonable levels for more than a few months. But the government’s money creation, combined with trillions in global wealth, were enough to bid up "cheap" assets as soon as the dust settled and the nagging pain of 0% returns on safe money drove people back in. 

That said, adding money to stocks now will lead to a fair but below average long-term return with a good deal of shorter-term risk if the economy can’t support itself without government training wheels. The mistake would be adding money now and removing it on a scary pullback. We’re going to try the opposite tack : cutting down our stock allocation soon and looking to increase it on future pullbacks. You can’t make money doing the opposite of a Buy  and Holder, but you can if you do the opposite of the buy high, sell low crowd.