Dow 13,000!

May 2, 2007

While it’s not quite the bubble-era Promised Land of “Dow 36,000,” the recent Dow 13,000 milestone is quite exciting, nonetheless. Any day now, it looks as though the S&P 500 (a better market benchmark that more closely mimics how most investors have fared) will break the record high it set over seven years ago. 

Of course, if you factor in the S&P 500’s dividend yield, investors are actually already up a bit on an ill-timed investment hypothetically made at the peak of the stock market's early 2000 insanity. That is, if their fund expenses didn’t eat up all of the dividend from their stock holdings. Most stock funds charge more than half the dividend yield of the stocks in their portfolios.

When stocks perform well, it's tempting to fall back in love with the market. We’ve seen fund investors increase their holdings in nearly every stock fund category, which is reason enough for us to consider some cutbacks in our model portfolios next month. As a group, fund investors tend to get it wrong, so easing up on the sort of funds they historically overindulge in has usually worked out well for us as an investment strategy. That being said, it's also a good time for us to examine the pros and cons of increasing our stock fund allocations – or what kind of mistake other fund investors could be making by raising their own stakes.

The stock market is a money machine, but it’s not magic. It doesn't churn out money no matter what. It can break down with no warning and take years to fix. 

In the long-term, stock market returns generally beat out real estate and bonds. Since corporate America grows income and dividends fairly automatically, (scandals and recessions aside) owning a piece of the action is a good idea. Unfortunately, this knowledge can cause investors to overvalue their stocks, particularly after periods of good performance. Call it too much of a good thing.

Now that diversification has become so easy and inexpensive, stocks are priced as a group. Investors can pay up for stocks because the chance of a few going bankrupt and destroying their portfolio is slim. If you own a piece of the S&P 500, it's a safe bet that the majority of companies in that index will still be around and earning even more money (and therefore enjoying higher stock prices) thirty years from now. Although this is fairly basic logic, it also means lower future returns. If, by law, investors could only buy one stock, (in any quantity) the stock market would trade at a single digit P/E ratio with a fat dividend yield – much like it did for a good chunk of history. These low prices are the investor's reward for assuming higher risk. Today, with instant cheap diversification, the risks of investing seem much lower. 

The other phenomenon that drives prices up and future returns down is loosely based on Dow 36,000 think. According to this line of reasoning, it's ridiculous for stocks to be as cheap as they were between 1930 and 1995. If stocks can be counted on to consistently outperform "safer" investments like bonds over the long haul, we might as well pay up for them now - a sound theory as diversification makes stocks safer. Anybody with a spreadsheet can show you that an investment with rising earnings is better than one with fixed earnings (like a bond or CD) – even if the dividend yield on stocks is a paltry 1.7% (as it is today), and a safe government bond is yielding just over 5%. Over time, the rising earnings will simply catch up. 

But behind these two sound foundations lies an equally disturbing reality. Neither of these facts can stop stocks from falling for any number of reasons outside of overvaluation. The damage sustained by a deep correction – no matter how irrational the trigger - can take more than your lifetime to fix. 

Even after the NASDAQ’s strong rise from the bottom of the 2002 bear market, many investors who plowed into NASDAQ-type stocks in 2000 may still never catch up to where their portfolio would be had it been invested in near zero-risk government bonds. The index remains down 50% from its high, and has paid out very little in the way of dividends along the way – certainly not the 6%+ that could have been locked in back in 2000. Perhaps by 2040, the NASDAQ portfolio will catch up to the all-government-bond portfolio. Investors in Japan’s market peak are also still down over 50% - nearly twenty years later.

The S&P 500's outlook isn't quite as bleak. Its fall in 2000-2002 was sharp, but its comeback has been nearly as strong. The index's dividend yield is also slightly better than the NASDAQ's. By our calculations, the buy-high S&P 500 investment will pass the all-government-bond investment by about 2030 - or thirty years after the original investment. The math behind this calculation assumes that you bought a 30-year government bond in 2000 and went all in to the S&P 500. We’re even giving stocks the benefit of the doubt by assuming an 8% total return on the S&P 500 every year until 2030 – probably an optimistic assumption, given the current dividend yield and slowing economy.

While today’s valuations mean a 50% fall in stocks is less likely now than it was back in 2000, it is by no means impossible. The next slide in the economy may result in a deeper recession than the one we saw in 2001. Interest rates could climb to 7% - how many investors would line up to buy stocks yielding less than 2% in such a scenario? How many could afford to borrow as liberally at higher rates? Even less predictable, any number of random events could cause a drop in stocks. Just as you'll see irrational behavior on the way up, you can also see it on the way down. 

We’re not trying to scare you away from investing in stocks or rationalizing an all-money-market allocation. We just think that now is a good time to cut back – just as we intend to increase our allocations if the environment changes and the brave turn meek. 

If the current environment continues, we’ll probably be making some changes to the model portfolios next month. Stay tuned.