Despite lackluster earnings growth, 2013 has certainly been a good one for U.S. stocks. Given the extremely strong returns from the major-market indices, investors might have also expected very strong earnings growth. Through Q3 2013, however, the trailing-12-month earnings growth for the S&P 500 was just 4.90%. In terms of forward estimates, this year has seen a continuous recognition that analyst projections were too rosy, resulting in a slow decline in forward estimates as the year progressed. In a nutshell, it is multiple expansion that is driving the strong equity returns.
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Going forward, valuations can certainly expand much more if investors are willing to remain focused on the belief that the Fed will never again allow stocks to enter a bear market. But as valuations continue to creep higher in this age of historically high excess liquidity (too much money chasing too few financial assets), I think each investor should ask him- or herself the following question:
Will the easy money policies that have directly and indirectly contributed to the incredible equity market returns of the past several years continue for the rest of my life?
I’m not convinced the experiment the Fed (and other central banks) are conducting will last the rest of my life. If you also share that opinion, you should seriously think about what types of securities you will want to own when the experiment ends. I don’t pretend to know when it will end or exactly where the chips may eventually fall. But I do know the following: (1) I don’t want to sit in cash and wait for something to occur that could take a very long time (opportunity cost is not worth it to me). And (2), there is one type of security that I know can pay me a respectable yield today (meet my cash flow needs/wants) and also most likely survive whatever may occur when the central-bank experiment reaches its eventual conclusion. The type of security I am referring to is individual bonds.
If we live in a world in which most, if not all, asset classes are being propped up by central-bank liquidity, then I want to own the one asset that I know will protect my principal and make planning for the future an easier task. Even if I buy an individual bond and it absolutely tanks in value from a mark-to-market perspective, as long as the issuer does not default on its obligations, the bond will eventually return to 100 cents-on-the-dollar. The same cannot be said about stocks.
While I think investors should have an allocation to stocks, I wouldn’t risk my retirement on a huge allocation to stocks—especially at today’s levels. Should you be concerned that the grand liquidity experiment central banks around the world are conducting will end during your lifetime, I think it is prudent to own a diversified, moderate-to-large allocation of individual bonds. You may not pick the perfect entry point, and your bonds may drop significantly in value the next time spreads widen or benchmark yields head much higher. But at the end of the day, as long as you have the wherewithal to hold your positions to maturity (and the issuer doesn’t default), you will get your money back. As long as you build a portfolio of individual bonds at yields that meet your cash flow needs, you can be confident in your ability to pay the bills in retirement. And as long as you are able to ignore your bonds’ mark-to-market movements, any bear market in bonds will have very little effect on you.
We live in a world in which policy makers heavily influence the direction of financial-markets prices. If you don’t think the iron grip that policy makers currently have over financial markets will last the rest of your life, it seems quite prudent to own individual bonds.
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