So far, it’s been a whipsaw year for stocks.
The Dow Jones Industrial Average began the year at 16,577 and declined 5 percent during January. February proved to be much better for stock investors as the Dow recovered much of the previous month’s loss, closing the month at 16,321.71. That translates to only a 1.5 percent loss for stocks during the first two months of the year.
Moreover, the S&P 500 Index — a broader measure of U.S. stock prices — ended February at a new all-time high, causing many investors to scratch their heads and again ask: “Are stocks too expensive?” And stocks may very well be overpriced, but regular readers of my Money and Markets columns know that valuation is a terrible timing indicator and tends not to matter much as investor psychology swings from optimism to euphoria.
What’s more, in an imperfect world with serious geopolitical tensions, where many economies are fragile or unstable and as a result are experiencing large capital outflows, the U.S. is in an extremely fortunate position. Volatility, however, is creeping back onto Wall Street, and low probability risks are rising.
But bull markets usually do not end when — as is the case now — business expansion is picking up and is supported by a highly accommodative monetary policy from the Federal Reserve. What’s more, there appears to be no “bad” inflation on the horizon. Real (after inflation) interest rates are low, and there’s excess labor capacity, which all suggest a favorable market environment where stocks can go higher.
|U.S. stocks remain the preferred investment.|
Instead, bull markets generally end when investors anticipate an inverted yield curve or a recession resulting in a decline in corporate earnings. That is not the case today.
Looking at interest rates, they continue to remain relatively low with the yield on the 10-year Treasury currently standing at about 2.6 percent. As I have pointed out in my Money and Markets columns, low interest rates are essential to supporting stocks’ lofty valuations.
And interest rates are likely to remain low for a while because the economic data shows that inflation remains contained. One of the most important pieces of economic data recently released was January’s Consumer Price Index, which showed both headline and core inflation coming in at only 1.6 percent on a year-over-year basis.
There are two primary factors keeping inflation lower and less volatile than in the past:
- The debt overhang that I have previously discussed extensively continues to be a drag on economic activity and consumer wages, which makes it difficult for companies to raise prices for their goods and services.
- Rising U.S. energy production has helped dampen historically volatile oil prices. Although oil prices are higher today than they were a decade ago, increased energy production in the U.S. has resulted in less energy-related inflation.
Low inflation is good for the economy and stock prices because it means the Federal Reserve is under no pressure to raise interest rates. What’s more, the minutes from recent Fed meetings show that several members emphasized that the Fed should support a “willingness to keep rates low” as long as inflation remains below its 2 percent target.
Newly appointed Chairman Janet Yellen provided even more reason for investors to be optimistic about stocks when she recently told House lawmakers in her prepared remarks to Congress that the Fed would pause its tapering of asset purchases if there was a “notable change” in the economic outlook, and increase asset purchases again if there were “a significant deterioration in the economic outlook — either for the job market or if inflation would not be moving back up over time.”
What all of this means is that we are likely to remain in the sweet spot for stock investors of tepid economic growth and low inflation, which I described in a recent Money and Markets column.
While inflation volatility is down, it’s been another story in the stock market. The VIX Index, the most popular measure of U.S. stock market volatility, has fallen a bit since it spiked in early February, but it’s still higher than it was at the start of the year.
Given the continued economic uncertainty, the likelihood of continued Fed tapering, the threat of war in Ukraine and a fragile environment in the emerging markets, I expect the relatively higher levels of stock market volatility to be with us for awhile. To be specific, I am not anticipating unusually high levels of volatility but, instead, I expect that stock market volatility will continue to rise from what have been recently unusually low levels.
This volatile and uncertain environment is why you should consider structuring your portfolio so that about 50 percent of your nest egg is invested in high-quality companies with exceptional earnings power and the other half is held in cash. The objective is to be well-positioned to take advantage of the increased volatility. When the market goes up, the carefully selected stocks in the portfolio rise, and when the market goes down, you have dry powder to add additional shares at bargain prices.
You should emphasize the following factors in the portfolio:
- U.S. stocks remain the preferred investment.
- Dividends are important because they add to returns in a low-yield environment, and should the market decline, you get paid a generous cash return while we wait for a recovery.
- Although the companies are U.S.-based, most should have a broad global footprint. At this juncture, I feel that’s the best way to profit from the flow of capital into the U.S. market and the superior growth opportunities that still exist overseas.
All in all, this approach has some great benefits: deep liquidity, upside participation and downside protection. And you won’t get caught reaching for yield because most of the companies in your portfolio will pay a growing and generous dividend.
Now is not the time to be filling up your boots with risk.