Gridley Associates Inc


Is it Safe Yet?

As we wrap up what has become a surprisingly good year for the stock market, it’s becoming more and more tempting to overweight stocks. With money market yields continuing near zero, and the increasing press about an imminent correction in bonds, stocks sure do look relatively appealing. It’s times like these that otherwise thoughtful investors abandon well thought out investment plans in order to chase higher returns. Unfortunately these deviations from plans frequently end badly, here’s why.

Stock market returns are volatile. Although it’s tempting to hop on the momentum train, there’s no guarantee you won’t get burned. Back in the 1930s the US economy was in a period of gradual economic recovery and high government stimulus not dissimilar to today. In the decade from 1930 to 1940 the stock market, in the form of the annual returns of S&P 500, reversed direction 6 times. In seven of those 10 years the S&P made double digit moves, and of those double digit returns 3 years were down and 4 years were up. For the most part if you were lucky and invested before a big up year, 3 years later you’d have made money. However, if you invested after a big up year, more often than not you were under water 3 years later. Following the old investment adage of "Buy low and sell high" is hard to do when the market has had a very big year. Stocks might go higher next year but we’ll probably need to see a major improvement in the economy for that to happen and as I write this that scenario doesn’t look like a very high probability.

Bonds, while unlikely to continue their big run up of the last couple of years, still have a role to play in most portfolios. I very general terms, two forces make bond investments lose value, inflation fears and weakening credit. With national unemployment now at almost 10%, inflation is unlikely to become a big problem anytime soon. Yes inflation may go up but as prices rise consumers will very likely cut spending and limit the potential damage. If we see inflation it’s unlikely to be very strong or prolonged. More importantly the credit picture, at least in the corporate world, is getting stronger, not weaker. For most companies profits are up and their spending is down so they have ample cash to use to pay down debt and rebuild their balance sheets - which tends to make the price of their bonds go up. Unfortunately that’s not the case for all companies (or the Federal Government for that matter) so it does matter which bonds you own. In general, bonds issued by weaker but improving corporate credits still have some room to improve this coming year. Even if they don’t the coupon interest they pay could look quite good.

Money market funds may offer very little in the way of current return but they do still offer considerable downside protection. Funny but not too many investors complained about zero returns when the market was in freefall back in late 2008. Having an anchor of spendable cash is still a very important component of many portfolios, even if the current returns are minimal. In fact, you may actually be better off now with negligible returns and minimal inflation than you would be in a higher yield environment where between inflation and taxes your real return is negative.

The point here is to stick with your plans. Overweighting your stock allocation, though tempting, may not make sense long term. It's usually not safe to chase markets so think twice before you abandon your well thought out portfolio plans. 

Randy Gridley

December, 2010