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There's nothing more frustrating than sitting on the sidelines as the stock market scales new heights. Should you put some cash to work with the Dow (.DJI) hitting a record close Tuesday or should you wait for a pullback?
More often than not, investors who try to guess the market's prevailing winds get blown off course: buying when prices are high and selling when they're low. Stock investors earned 3.5% a year on average from 1992 to 2012, compared to the S&P 500's (.SPX) annualized return of 7.8%, according to a 2012 study by the consulting firm Dalbar. The main culprit: poor market timing, according to the study.
Of course, it's hard to tune out the market chatter, which tends to heighten investor anxiety about what to do. Bears argue stocks are fairly valued or on the pricey side: The S&P 500 is now trading at 17.9 times trailing earnings for the last 12 months, according to Birinyi Associates, about 15% higher than the average trailing P/E of 15.5 since the 1870s.
Stocks also look pricey based on the market's average earnings over the last five years, according to Doug Ramsey, chief investment officer of the Leuthold Group, a value-oriented asset manager in Minneapolis. By Ramsey's measure, the S&P trades at 20 times earnings, well above the median 16.5 since 1926. At these levels, returns have averaged 5% a year in the following 5 to 10 years, below the 10% average return since 1926.
As bulls see it, these are backward-looking measures that don't reveal much about where stocks may be headed. Based on forward-looking estimates, the S&P 500 trades at about 13.4 times earnings, below the average 14.9 over the last 25 years, according to Thomson Reuters. Many companies are reporting near-record profit margins, and 70% of companies have beaten fourth quarter earnings estimates — ahead of the 62% in a typical quarter, according to Thomson Reuters.
Even after more than doubling over the past three years, the S&P 500 doesn't look overvalued, says Jim Miller, president of Woodward Financial Advisors in Chapel Hill, N.C. The two previous times the S&P peaked above 1,500, in 2000 and 2007, P/Es were higher, with the S&P trading around 29 times and 17 times forward earnings respectively. Now, corporate profits are keeping up with stock prices, he says, keeping the market's P/E in line.
"Everyone was excited to buy stocks in 1999," he says, "yet the market was twice as expensive." Today, you can buy the market for half the valuation, making the starting point more attractive, in his view.
It's also important to remember that stocks are a long-term investment, says Matthew Fruhan, manager of the Fidelity Mega Cap Stock Fund (FGRTX). Many people look at the market through a one-to-two-year lens. But that's too short a time-frame given the volatility of earnings and potential for market setbacks due to a political or economic crisis.
While stocks move higher over the long-term, they can be highly volatile near-term with swings of 20% or more in any given year. One way to lower your risk of buying right before a downturn is to average into stocks over time, says Georgia Bruggeman, an adviser with Meridian Financial Advisors in Holliston, Mass. For example, you might invest $2,500 in a stock fund every 30 days, regardless of the market's direction. By investing gradually, you can lower your average purchase price should the market head lower.
Also, don't stray from your long-term investment plan. For example, if you're in your 40s, you may want a mix of 65% stocks, 30% bonds and 5% cash — a classic balanced portfolio. You'll need to rebalance periodically, making sure your positions don't deviate too far from your long-term targets. And most advisers recommend less stock exposure and more fixed income for investors closer to retirement or withdrawing cash from their portfolios. The idea is the mix gradually gets more conservative.
"The most important decision is how much you invest in stocks versus bonds," says Bruggeman.
If you're thinking of putting some money to work, you may want to look at a low-cost ETF or index fund. The following are a few suggestions, based on our research and the opinions of analysts and advisers. You should do your own research or consult an adviser before investing.
For broad exposure to the U.S. market, the iShares Core S&P 500 ETF (IVV) tracks the S&P 500, offering access to major names such as Apple (AAPL), Exxon Mobil (XOM) and General Electric (GE). Morningstar analyst Michael Rawson refers to it as a "solid core equity holding." It yields 1.9% and costs 0.07% in annual fees, making it one of the lowest-cost ETFs on the market, according to Morningstar. It can be traded for free on the Fidelity platform.
Many fund companies offer similar index funds, including the Fidelity Spartan Total Market Index Fund (FSTMX). The fund offers a bit broader exposure, tracking an index of about 5,000 U.S. stocks. It costs 0.1% in annual fees and yields 1.8%.
Another ETF worth considering is the iShares Russell Mid-Cap Value ETF (IWS), according to Carl Friedrich, an adviser with Piermont Wealth Management in New York, who uses the ETF for his clients. The ETF tracks an index of midsize stocks, screened for criteria such as price/book ratio and earnings growth estimates. It returned 12.1% annualized over the last decade, beating the 8.4% annualized return of the S&P 500, according to Morningstar.
The ETF closely tracks its index, says Friedrich, and it's cost effective with an annual expense ratio of 0.28%. It yields 2%.
The downside: Midcap stocks tend to be more volatile than large caps and move closely in line with the S&P 500, offering minimal diversification benefits, according to Morningstar's Rawson.
For large-cap exposure, Friedrich goes with the Mairs & Power Growth Fund (MPGFX). The fund beat 98% of peers over the last five years with a 7% annualized return, according to Morningstar. "It has gotten the job done by stock-picking," says Friedrich. Indeed, the fund's top holding is paint company Valspar (VAL), followed by conglomerate 3M (MMM), neither of which is a top-10 name in the S&P 500. It yields 1.5% and costs 0.72% in annual fees.
One drawback: The fund yields less than the S&P 500 and has similar volatility. It costs $75 to buy shares on the Fidelity platform.
Foreign markets offer some diversification benefits since they don't always move closely in line with the U.S. Foreign markets also look cheaper than the U.S., based on average earnings per share over the last five years, according to the Minneapolis money manager Ramsey.
The iShares MSCI ACWI ex U.S. ETF (ACWX) offers broad foreign-market access. It tracks an index covering 85% of foreign stock market value, investing in a mix of developed and emerging markets, and can serve as a "core foreign holding," according to Morningstar analyst Patricia Oey. It yields 2.6% and costs 0.34% in annual fees.
The downside: The ETF is 43% more volatile than the S&P 500, according to iShares. Investing in foreign stocks also involves currency risk, which can be a headwind for U.S.-dollar based investors.
Dividend yields tend to be higher abroad and one way to access them is through the PowerShares International Dividend Achievers Portfolio ETF (PID). The ETF tracks an index of foreign dividend payers, screened for companies that have raised their annual dividends for the past five years. That helps keep "distressed" stocks out of the mix, notes Morningstar analyst Abby Woodham.
The ETF beat the MSCI EAFE Index over the last three years, returning 11.6% annualized versus 7.9% for the index. It yields 2.7% and costs 0.56% in annual fees.
The downside: The ETF's holdings are highly correlated with U.S.-based rival companies, providing minimal diversification benefits, notes Woodham. The expense ratio is on the pricey side for a dividend-focused ETF.
If you're considering an actively managed fund, Oakmark Global Select Fund (OAKWX) has racked up a strong record. The fund invests in both the U.S. and foreign markets and gained 9.9% annualized over the last five years, beating 99% of peers, according to Morningstar.
Run by two veteran "value" investors, Bill Nygren and David Herro, it holds 20 stocks, selected for what the managers believe is a deep discount to the companies' value. Overall, the fund has been "less risky and more rewarding than its typical rival," according to Morningstar analyst Shannon Zimmerman.
The downside: Around 28% of the fund is in financials, more than double that of the average global stock fund. That could hold back returns if financial stocks perform poorly. The fund is also highly concentrated in a handful of companies, elevating the risk that a few laggards could drag down returns.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services. He does not own any of the securities mentioned in this article.
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