Another wobbly week for stocks, another chorus of experts telling investors this is no time to panic. But for the nervous, this might actually be a pretty good time to panic, just a little, and with a plan.
Two reasons: First, savers can get a safe 2% on their cash stashes for the first time in a decade, and that figure is likely headed for 3%. That’s especially true with banks that don’t have vast, costly branch networks to support. Marcus, a relatively young retail banking unit of Goldman Sachs, was recently offering 1.95% a year on balances over $1, according to Bankrate. CIBC Bank USA, a division of the Canadian Imperial Bank of Commerce—one of the five banking bigs up north—was paying 2.16%, and American Express National Bank was at 1.9%.
There is little sign of an economic recession on the horizon, which is a good thing for stocks. But the flip side is that there’s little reason for the Federal Reserve to slow its pace of interest-rate increases. Market strategists say that’s no problem for stocks, but statistically, they’re flying blind. Goldman’s stock forecasters reckon the U.S. market can rise as long as the 10-year Treasury yield stays below 4%, versus a recent 3.1%. Bank of America Merrill Lynch says 5% seems about right.
The truth is, that kind of analysis is based on what stocks have done in the past in response to rising rates, but there never quite was a point in U.S. history when investors were starved for yield for a decade, and then suddenly fed, at a moment when stock ownership is broad and sell orders are a click away. The Federal Reserve dropped rates to near zero at the end of 2008 and left them there until 2015, and they didn’t reach 1% again until last year. Now, it is signaling 3.1% by the end of next year.
Judging by data from Bank of America Merrill Lynch, ordinary investors have lately been buying stocks during the dips, while pros haven’t. If the market falters for a while, and savings rates approach 3%, the retail herd could soon begin lightening up on stocks in favor of bank deposits.
The second reason is that even after the recent selloff, the U.S. stock market is a little pricey, which raises the chances that long-term returns from here will be a little below average.
The subject of whether stock prices are normal or not is fraught with analytical slush puddles, because there are many ways to measure earnings (with and without nonrecurring bad stuff, for example), and many different baselines to choose among. For example, the S&P 500 index (.SPX) traded recently at 16.8 times estimated 2018 operating earnings, and the 20-year average is a comforting 17.1, according to FactSet. But the past 20 years are surely not a good proxy for normalcy, with two stock bubbles, a global financial crisis that temporarily vanished earnings, and a long stretch of rock-bottom interest rates. A 2000 study by an economist at the Kansas City Fed Bank found the average trailing price/earnings ratio to be 14.5 over 127 years, and that was using a stricter definition of earnings than is commonly used today.
Accurately predicting what the stock market will do next year is impossible. Inaccurately predicting it is easy: It will rise. That’s what it tends to do, on average. But the margin of error on that prediction is wider than a canned ham. Investors can be more confident guessing about average returns over the next decade.
When valuations are low, future returns tend to be high. The best guess now is that future returns will be a little below average. And yes, early forecasts point to S&P 500 earnings rising 10% next year, which is peppy growth. But remember, in the years leading up to this one, those early forecasts tended to come down to reality as reporting time approached. This year has been an exception, because of a large corporate tax cut signed into law just before last Christmas. If we revert to the prior pattern, next year’s earnings growth might be closer to 5%.
Put those two reasons together, and it means the opportunity cost for panicking now might be relatively low. The pay for sitting on cash has certainly improved, and less certainly, the richest stock returns might be behind us for a while.
But a low opportunity cost isn’t the same as no cost. Stocks remain likely to outperform both bonds and cash over time, because that’s what they do. Stocks represent companies, and bonds and cash represent the cost of financing, and companies wouldn’t exist if not for their ability to out-earn the cost of financing over time. So investors who don’t have a history of panic-selling their stocks during market downturns should stay put.
The rest might want to do some late-cycle soul searching. If the Dow Jones Industrial Average (.DJI) were to drop, say, another 3,000 points in a hurry, would you dump everything? If so, consider quietly panicking now, just a little, while other investors are buying on the dips.
If your regular stock allocation is 60%, and market gyrations are making you nervous, perhaps take that number down to 50%. Don’t go too low, and decide now on a schedule for returning to your regular allocation by, say, shifting a couple percent a year back to stocks over the next five years.
As for what to sell, if you own individual stocks, start with companies with high dividend yields but little dividend growth, and companies with little earnings now, and little expected soon, but plenty of promise for wonderful earnings down the road. The first type of stocks tend to trade like bonds, falling as interest rates rise. The second, those future growers, have probably done exceptionally well in recent years, when interest rates were near zero, and the cost of waiting for growth stories to play out was low. But as rates rise, investors could become less patient for story stocks.
What to buy? Try nothing for a while, and soak up some of that savings yield. If you need to put more than the $250,000 FDIC insurance limit into cash, find a sweet spot on the Treasury yield curve. For example, that one-year Treasury bill yield of 2.64% looks tasty. But remember, the FDIC limit is easy to get around—a His account, a Hers account, and a Theirs account, and you’re already up to $750,000, even without talking about individual retirement accounts and such.
If the stock market soars next year, scold yourself only gently, because you sold only a little. And if our beloved bull rolls over and snorts its last breath, there will be no need to panic, because you will have already done so, and at the best possible time: before everyone else.
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