Taking the stock market’s temperature

It’s a balmy 53 degrees here, which isn’t bad for January, but the Standard & Poor’s 500 is hotter than a fire ant’s furnace. As of Jan. 25, the blue-chip index has gained 6.16%, including dividends. How do you know when hot is too hot? You can get one hint from the aptly named Thermostat fund.

A rising stock market, in and of itself, is no reason to panic. Typically, a really good year is followed by at least an OK year. When the S&P 500 gained 26% in 2009, it followed up with a 15% gain in 2010. Similarly, the index gained 13.46% in 2014 after a 32.31% advance in 2013.

What matters is how stock prices measure up against corporate earnings. The basic measure is the price-to-earnings ratio, which simply divides a stock’s price by its previous 12 months’ earnings.

The lower the PE, the cheaper the stock is, relative to earnings. A $50 stock that earned $3 last year has a PE of 16.7. Changes in either price or earnings affects the PE ratio. If the stock’s price drops to $35, its PE is 11.7. If its earnings fall to $2 a share, its PE rises to 25.

It’s not infallible. PEs were high in early 2009 because earnings were so low. Some argue that it’s best to use earnings estimates, rather than past 12 months’ earnings, to measure PE. There’s some wisdom to this: The stock market looks forward, not back. On the other hand, earnings estimates are fiction, and historical PEs are a tad more fact-based. You can get both on Morningstar’s site.

All of which brings us to the Columbia Thermostat Fund (CTFAX), created by storied value investor Ralph Wanger. The Thermostat fund adds bonds to the portfolio as the market heats up, based on the market’s price vs. long-term earnings. When stocks become cheaper, it adds more to stocks and reduces its bond holdings. The fund also has rules to prevent big swings in its holdings.

What’s the fund’s current reading? It’s got just 7.31% of its portfolio in U.S. stocks, and 2.43% in international stocks. Even by the fund’s cautious nature, that’s pretty low. Here’s how the fund’s stock allocation has varied over the years:

Source: Columbia Threadneedle Investments

The fund’s return the past 10 years has been above its category —  conservative allocation, by Morningstar’s reckoning. Nevertheless, its absolute return hasn’t been particularly spectacular. The fund has gained an average 5.35% a year the past decade, in part because it has been so conservative during bull market years.

Nevertheless, the fund serves as a useful market barometer: It’s hard to argue that most stocks are cheap now. If you’re thinking of turning up the temperature in your portfolio, you might want to take another look at the thermometer.

The monster under the bed

Alfred E. Neuman

One of the fun things about being a personal finance writer is the number of “Dear idiot” letters you get. Stories about the Federal Reserve Bank tend to get them. (“You idiot! Don’t you know the Federal Reserve is evil?”). So do stories about taxes. (“You idiot! Don’t you know that Girl Scout cookies are deductible?”)*

Inflation is another source of contention, particularly if you note that inflation has been moderate, which it has been, whether you’re using the Consumer Price Index, the GDP Price Deflator, or even the Billion Prices Project. But your perception of inflation depends on what you spend the most on. If you have kids in college or if you rely on prescription drugs, your personal inflation rate is pretty high.

Those who grew up in the 1970s and early 1980s recall when a 5% inflation rate was considered moderate, as opposed to the most recent 2.2% rate. And they fear a resurgence of inflation, with good reason: It erodes the value of retirement savings and pensions.

The consumer price index has averaged a 1.7% annual gain the past decade, and actually dipped into deflation — a period of falling prices — during the Great Recession. And the forces of deflation are still all around us: The favored tactic of technological disruptors such as Amazon, Uber and others, is to drive prices down and drive competitors out of business. This was a favored tactic of the Gilded Age, aided even further by the gold standard, which tends to favor deflation over inflation. I go on at some length about the subject here.

The Federal Reserve traditionally raises interest rates to slow the economy and cool inflation, and it lowers rates to stimulate the economy and encourage inflaton. The Fed has already nudged short-term interest rates higher five times since 2015, but rates are still extraordinarily low by historical standards. Most think the Fed is acting not out of fear of inflation, but out of fear of not having any ammunition to fight the next recession, whenever that may be.

Tomorrow’s Consumer Price Index report hits the headlines at 8:30: The consensus forecast is for a 2.1% year-over-year change for 2017. Anthing higher, particularly for the core CPI (less food and energy) is likely to make for an upsetting day in the bond market, where yields have been creeping higher and prices lower. The iShares Core U.S. Aggregate Bond ETF (AGG), a useful proxy for the bond market’s total return, has already fallen 0.57% this year, according to Morningstar.

Right now, there’s a balance between inflationary forces — a strong economy and fiscal stimulus — and deflationary ones. In the normal course of events, the Fed tightens too much during inflationary periods, causing the economy to slow, earnings to fall, and stocks to tumble. So there’s reason to watch inflation warily.

Is it time to panic? Well, no. It never is. If you’re particularly concerned about inflation, you might consider a fund that invests in Treasury Inflation Protected Securities, whose price is keyed to changes in the CPI. The current yield on TIPS shows that Wall Street expects inflation to remain at 2% the next 30 years. If you think they’re wrong, then one good pick would be Vanguard Inflation-Protected Securities Fund Investor Shares(VIPSX).

It may well be that technological changes have redefined the upper bound of inflation in the economy. Tomorrow’s CPI print is no reason to go running from the room in terror. But it’s worth keeping an eye on the monster under the bed this year.

* They aren’t, if you eat them.

The busy season for outlooks

Economists and money managers give forecasts because people ask them to, and this is the time of year when people like me ask people like them for their forecasts.

You have to take all forecasts with a grain, if not a block, of salt. Nevertheless, I got the chance to interview some smart people, such as Will Danoff, manager of Fidelity Contrafund, who’s bullish on the U.S. and technology. And then there’s Jerome Dodson, manager of Parnassus, who has the crazy notion that companies that treat employees well will prosper.

Anyway, here’s their outlooks for 2018, along with Mark Mobius of Franklin Templeton, Robert Doll of Nuveen and Joe Davis of Vanguard.

http://www.investmentnews.com/article/20180106/FREE/180109962/2018-outlook-in-equity-investing-is-mostly-bright?issuedate=20180108&sid=outlook20170108

A word for the naive: Well done!

One of the duties on the long list of grownup responsibilities is to figure out how much money to put into your company’s 401(k) offerings. Many people, rather than figuring out their long-term goals and tolerance for risk, simply split their money equally between all the options.

This is known as the 1/n portfolio among the nerdly, or more generally, the naive portfolio. And its results generally aren’t that bad, even when compared with high-powered optimized portfolios.

What makes the naive portfolio more interesting is that companies don’t choose their 401(k) offerings much differently than naive investors do: That is, they tend to offer very large funds with a good near-term track record. The odds are good that your fund’s 401(k) offerings are simply the largest funds available. Here are the 10 largest mutual funds, ranked by assets, and how they performed last year.

Name Ticker Morningstar Category 2017 gain
Vanguard Total Stock Mkt Idx Inv VTSMX US Fund Large Blend 21.05%
Vanguard 500 Index Investor VFINX US Fund Large Blend 21.67%
Vanguard Total Intl Stock Index Inv VGTSX US Fund Foreign Large Blend 27.40%
Vanguard Institutional Index I VINIX US Fund Large Blend 21.79%
Vanguard Total Bond Market Index Inv VBMFX US Fund Intermediate-Term Bond 3.46%
American Funds Growth Fund of Amer A AGTHX US Fund Large Growth 26.14%
American Funds Europacific Growth A AEPGX US Fund Foreign Large Growth 30.73%
Vanguard Total Bond Market II Idx Inv VTBIX US Fund Intermediate-Term Bond 3.51%
JPMorgan US Government MMkt Capital OGVXX US Fund Money Market – Taxable 0.77%
Fidelity® 500 Index Investor FUSEX US Fund Large Blend 21.72%

Dividends, gains reinvested through Dec. 29. Data via Morningstar.

The portfolio’s total return: 17.8%, which lags the Standard and Poor’s 500 stock index by a bit more than four percentage points. On the other hand, the portfolio is only 70% invested in stocks, which is what you’d want in a diversified portfolio. The 20% allocation to bonds and 10% allocation to money market securities (as well as a 10% slug of foreign stocks) are reasonable diversification for a moderate portfolio.

Of note, too: This is a dirt-cheap portfolio, with an average expense ratio of 0.25%. Low expenses are one of the single most important predictors of future returns: The less you give to your fund company, the more you get to keep for yourself.

What could go wrong? Three things, none of which seem terribly serious. The first is the preponderance of index funds, which will guarantee you nothing more (or less) than what the market does. If the S&P 500 goes down 20%, this portfolio’s two S&P 500 index funds will go down 20%, too. But it’s unlikely that actively managed funds will get out of the way in time, either: Most didn’t during the 2007-2009 bear market. And remember, the portfolio is only 70% in stocks.

The second is that, thanks to the market’s runup, you’re now about 74% in stocks. This is not particularly something to worry about at the moment. Now, if you had been in these 10 funds for the past 10 years, your portfolio would be 81% in stocks.  This is better than watching your stock allocation shrink. But you might have a greater exposure to stocks in the next bear market than you’d like. If that’s the case, you should sell enough of your winning funds and reinvest the proceeds in your laggards, bringing you back to your original 70% stock allocation.

The final problem is that the 10 funds in the chart are there because they have been wildly successful in the past decade. Money follows success.  It’s a good bet that the 10 largest funds today won’t be the 10 largest in the next decade. When you’re at the top, there’s nowhere to go but down.

Unfortunately, if you’re simply investing in what the company offers, there’s not much you can do about that. Nor, for that matter, can you predict accurately what the 10 largest funds of 2028 will be. The main thing is to keep an amount in stocks that you can live with.

 

 

 

 

 

 

The season for giving

Most people who invest are periodically troubled by the actions of the companies whose stock they buy. While you probably won’t see a headline like “Equifax Sought in Bar Stabbing,” you probably have seen headlines like “Equifax CEO Richard Smith steps down amid hacking scandal.” You may also have noted that Mr. Smith left the company with an $18 million pension. Heck, I would have run the company into the ground for half that.

It’s no wonder that funds that screen for environmental, social and governance factors are becoming increasingly popular. Of those three factors, I’d argue that governance is the most important. (In fact, I did, right here in my latest column for InvestmentNews). Funds like Parnassus (PARNX) have fared extremely well by investing in companies that treat employees well, don’t cut corners to save costs, and don’t pay CEOs gargantuan salaries.

It’s the social part of ESG investing that gets sticky. Just this morning I got a press release for the eVALUEator Biblically Responsible Index (BIBLX). According to the announcement, “The index is designed to invest solely in companies with activities and practices consistent with Christian values. These standards allow BIBLX to limit portfolio exposures to practices related to abortion, pornography, alcohol, tobacco, gambling and anti-family entertainment.”

You may not be surprised to learn that the world isn’t in agreement on all Biblical principals. Mennonites, for example, would object to defense stocks; others cite an obligation to be good stewards of the earth and would avoid polluters. And, of course, there are those who don’t use the Bible as the basis for their faith.

If you can’t find a social fund that fits your specific views, it might be more effective to invest in a broadly based index fund or other fund and simply donate the proceeds to a charity that addresses your favorite cause. If you donate appreciated shares of a stock or fund, you can also sidestep any taxes on capital gains. And there would be a certain symmetry in selling shares of a major polluter and donating the proceeds to The Nature Conservancy or cashing in shares of a tobacco company and giving the money to The American Cancer Society.

 

Awash in cash

People who like dividend stocks might find that technology stocks are the type of stocks that they like.

For one thing, they have enough cash to buy several small European countries. “Companies have enough money to do whatever they want, and that’s before potential reparations” from the tax bill, noted Howard Silverblatt, senior index analyst for S&P Dow Jones Indexes. And how. All told, about $1.8 trillion is cooling its heels on corporate balance sheets, and much of that is on tech balance sheets. Here are the 10 companies with the biggest cash stashes:

Apple has another $195 billion in “long term investments” on its balance sheet, which skeptics might label as “pretty darn close to cash.”  And overall, IT is the second-largest dividend payer, behind financials.

Why does IT have so much cash, aside from being immensely profitable? One reason might be that IT went through a near-death experience in 2000-2002, and they have learned the lesson that cash is your best friend in hard times. (Banks, which have gone through several near-death in the past 50 years, never seem to learn that).

Another is that IT companies rely on innovation to survive, and innovation doesn’t come cheap. Either you have to hire top people (and pay them well to keep them) or you have to pay up to buy innovative companies. That requires cash, too, although having an extravagantly valued stock price is good, too.

What’s interesting is that many of these stocks aren’t insanely priced. Apple sells for 14.4 times its estimated 12 months’ earnings, and pays a 1.45% dividend, too. Cisco sells for 14.4 times earnings and pays a 3.0% dividend. Oracle pays a 1.48% dividend and sells for 15.3 times earnings. Only Facebook, which sells at 26.8 times its expected earnings (and doesn’t pay no stinking dividend) fits the profile of the gunslinging tech company of yore.

(The two biotech companies in the chart, Amgen and Gilead, also rely on heaps of cash to continue innovation, are cheap, and pay good dividends. Coca-Cola is, well, Coca-Cola).

During the 2007-2009 bear market, and for some time thereafter, technology was the sector with the highest dividends, precisely because it had the cash on hand to do so. Banks were too busy staving off bankruptcy. For investors who like dividends and dislike bankruptcy, large-cap IT seems to be a reasonable bet.

Naturally, there’s an ETF for that: The First Trust NASDAQ Technology Dividend Index Fund (TDIV), which currently yields 2.14% on a trailing basis. The fund doesn’t have the sizzling returns that an all-tech fund has — it’s up a mere 21% this year, vs. 36% for the technology sector — but that’s not why you buy a dividend fund. Assuming these companies don’t waste their money on something foolish, like buying several European countries, they could be a good long-term investment for dividend investors.

Taxes and the urge to merge

Tax reform, in whatever final shape it takes, is likely to put lots of money into corporate hands. While these companies already have lots of cash — a record $1.8 trillion in nonfinancial companies in the Standard & Poor’s 500 index — giving them more cash may give them an incentive to actually, you know, spend it. I talk about one likely option in my latest column, here. 

On another topic, the Baby Boom Generation spans the years 1946 to 1964. There’s a big difference between the early Boomers and their younger siblings: If you were born in 1946, you came of age with the Beatles, the Vietnam War, Lyndon Johnson and Richard Nixon. If you were born in 1964, you grew up with The Clash, gas lines, Jimmy Carter and Ronald Reagan. More importantly, older Boomers are more likely to have pensions and more likely to have taken a beating from the past two bear markets. Younger Boomers? They probably don’t have pensions, they face soaring college tuition costs for their children — and some will retire just as the Medicare Trust Fund runs out of money. You can read about it here.