The first three months of 2013 was a helluva year for stocks. The S&P 500 gained more than 10%. Six of the 10 largest companies in the index, including Procter & Gamble (PG), Johnson & Johnson (JNJ) and Google (GOOG) posted gains well above the market average.
The only Debbie Downer in the top 10 just happened to be the largest cap U.S. company. Yep, Apple (AAPL) which fell nearly 15%.
Yet despite the major stock indexes flirting with all-time price highs (based on total return they blew past their 2007 highs last year) it’s interesting how we keep hearing that stocks are “fairly” valued, not overvalued, and that there’s more upside to be had.
In times like these it can be helpful to step back and gauge the potential hurt if things take an unexpected turn.
For starters, “fairly valued” depends on your point of reference. The cyclically adjusted PE ratio (also known as the Shiller PE) tracks the S&P 500’s average PE ratio over the trailing 10 years. The long-term historic average is 16. At the end of the bear market it was clearly signally stocks were undervalued, as the CAPE fell below 15. Today, not so much.
Moreover, some of the most popular stock themes of the past few years have been framed as doubly smart because they provide downside protection. What’s less talked about is that the protection is only relative. In absolute terms, both dividend stocks and low-volatility strategies get creamed in down markets, just less creamed than the market average.
Income starved investors who’ve flocked to the likes of AT&T (NYSE:T), 4.9% dividend yield, Consolidated Edison (ED), 4.2% dividend yield, or even Intel (INTC), 4.3% dividend yield, might want to take a long hard look at what happened to these strong income stocks from mid-September 2008 through the market low in early March 2009. Yep, they beat the market average, but….
Low-Volatility stock indexes have also become a strategic darling over the past year or so. There’s a bit of a mad rush among ETF providers to roll out rivals to the granddaddy, PowerShares S&P 500 Low Volatility ETF (SPLV), which has seen its asset base balloon to $4.2 billion. The LowVol approach is indeed a compelling strategy: As we’ve written before at YCharts, over full market cycles it has delivered better returns with lower volatility. Cake and eat it too. Well, sort of. Again low volatility only offers relative solace in a down market.
The five largest holdings in the PowerShares S&P 500 Low Volatility portfolio today are Johnson & Johnson, HJ Heinz (HNZ), PepsiCo (PEP), Clorox (CLX) and General Mills (GIS). Here’s how those five fared in the 2008-2009 meltdown.
Junk bonds may be the biggest unappreciated risk out there. A common refrain heard these days is that the improving economy is actually good news for junk bonds. Indeed, junk’s fate is more tied to the economy than interest rate changes. So in an improving economy where interest rates start to rise, junk will do better than high-grade debt. But again, for today’s relatively low 5%-6% yields, you’re packing on some serious downside hurt if the markets take a step back. Here’s how a leading junk ETF fared (JNK) in 2008-2009, compared to a “core” bond ETF that traffics in high-quality corporate and government debt.
Carl Richards, financial advisor, Sharpie Pen artiste at the New York Times Bucks Blog and author of The Behavior Gap suggests a simple thought exercise before making a new investment. Ask yourself: If you’re right about an investment, what impact it will have on your life. Then, ask yourself the impact if you’re wrong. Finally, ask yourself if you’ve been wrong before.
That seems especially trenchant in today’s market. All the good news chatter -- and growing brokerage statements -- makes it easy to forget the potential risks. Nobody ever had their heart broken taking some profits in a strong bull market and waiting for the next pullback to reinvest.
Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at firstname.lastname@example.org.
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