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Prudent Strategies for a High-Flying Market

Mon, 25 Nov 2013

Investors queasy over market valuations may consider rebalancing, augmenting their cash stakes, and tilting toward undervalued pockets and proven flexible managers, says Morningstar's Christine Benz.

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Video Transcript

Jason Stipp: I'm Jason Stipp for Morningstar. The S&P 500 year-to-date is now up almost 30%, following a 16% return in 2012, and now the trailing five-year return annualized is 20%. So, you can't blame some folks for thinking stocks might be peaking. What should you do?

Here to offer some coping strategies for a fully, or maybe overvalued, market is Christine Benz, our director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: There is no doubt that we've seen a strong multiyear market record rally at this point, but there is some difference of opinion as to whether stocks are terribly overvalued or just fully valued right now. There is a range of opinions out there.

Benz: There is. Grantham, Mayo, Van Otterloo came out last week with a forecast for domestic equities, forecasting a negative real return for U.S. stocks over the next seven years.

I happened to see Robert Shiller speak at the recent AAII's national conference, and he was forecasting a 2.5% real return for stocks over the next decade. I would say those two would be at the pessimistic end.

Jack Bogle, when I interviewed him back in October, said that he is thinking stocks look slightly overvalued, but he still was forecasting more positive real returns for equities over the next decade. Warren Buffett has also said that stocks are in a zone of reasonableness--I believe that was his wording--right now. So he doesn't think that they're tremendously overvalued, but he doesn't think they're undervalued, either.

I think the really notable absence in all of this, Jason, is that among these respected observers, there really aren't that many bulls. Even though you have the bearish, and people who are somewhat neutral on stock valuations currently, it's hard to find people who are really pounding the table for stocks given the runup that we've seen recently.

Stipp: We can also aggregate our own Morningstar analyst fair value estimates to get a sense of where we think the market is valued right now. What does that data say?

Benz: I look at this all the time on our market fair value graph. 1.04% is the average price-to-fair value for the stocks in our global coverage universe. That's at the high end of where that price-to-fair value has been historically.

Stipp: So we have a range here. Stocks certainly aren't a screaming buy. They look fairly valued to some folks, and they look relatively overvalued to some other folks.

Maybe a good place to start is how to cope with this is what not to do, and certainly avoiding mistakes can be a big part of your success.

Benz: I those so. I think it may be tempting for investors right now to say I want to pull back, maybe pull out of stocks a little bit, and wait for a more opportune time to get back in. I would say that that's market timing, and it's fraught with potential pitfalls. The key one is that oftentimes when people do … make a substantial sale of their equity holdings, they are left with what I call seller's remorse. They are watching the market maybe trend up for a little bit after they've sold, and they really wonder, did they do the right thing? Or if the market pulls back, is it time to get back in? Selling a big share of your equity holdings really can unleash problems of its own. I would be very careful with an all-in, all-out type of strategy.

Stipp: Certainly markets can stay somewhat fully valued or overvalued for a little bit of time, or they might just kind of be flat for a little while. So there's really no telling exactly what's going to happen, at least in the short term.

Benz: I think that's absolutely right, and one potential argument in favor of stocks right now is a lack of really exciting alternatives. You see where bonds are right now. Cash certainly isn't at a competitive yield. So, investors may continue to bid stocks up for a while here, simply because of the fact that there aren't that many other great things to invest in.

Stipp: Making a dramatic change in my stock allocation just because I'm worried that stocks might be a little bit high is probably not advisable for most investors. So what should I do instead? It doesn't look like stocks are a screaming buy either. What's your take on that?

Benz: I've been advising for a while that one tack investors should be looking at right now is to be thinking about rebalancing their portfolios. So assuming that they have some sort of strategic asset allocation framework that they're working within, look at where your current weightings are versus those targets. A portfolio that was 50% equity, 50% bond five years ago would now be about 64% equity, 36% bond. This is an S&P 500, high-quality bond portfolio.

If you've been very hands-off through this rally, chances are you've seen your equity holdings step up and up and up, probably higher than your target weightings. I think of rebalancing as kind of a "chicken" tactical asset allocation play. It's a way to be a little bit tactical, be sensitive to the fact that stock valuations aren't what they once were, but it's not market-timing, because you're not taking all of your equity holdings off the table.

Stipp: Christine, you just mentioned that bonds aren't necessarily very attractive, either. If I'm doing this, I'm effectively buying fixed income and selling some of my stocks. Should I be thinking about fixed income as the place to put that money?

Benz: I know there is a lot of trepidation over fixed income right now. Yields are very, very low, and people are concerned that if we do see bond yields trend up, that will tend to hurt bond prices. This doesn't seem like a great market to be taking a lot of risks with one's fixed-income portfolio. My general advice for people who have done the asset allocation work and decided that they need more bonds is that they probably want to keep that portion of their portfolio fairly high quality for sure, because we have seen the stampede into lower-quality bonds. Yields there really, in my view, aren't sufficiently compensating people for some of the risks, so you want to keep your quality high and generally not be holding long-duration bonds at this point, either. I would say intermediate- and short-duration, high-quality bonds are the place to be.

Stipp: The other major asset class that folks will put money in is cash, and you mentioned that cash has essentially zero yield at this point, but the value of cash isn't just in its yield.

Benz: That's right. I think another strategy that one could look at, in addition to doing rebalancing, is potentially to raise a little bit of cash, because one side effect of the market being fully valued, reasonably valued, whatever you want to call it, is that it tends to be more vulnerable to macroeconomic news that can shake the stock market. I think it's a reasonable time to be holding perhaps a little bit of your portfolio in cash rather than holding it in longer-term securities. That way you can be opportunistic. You can add to whatever category happens to get knocked down the furthest if, in fact, stocks or even bonds sell off.

Stipp: How much of a cash stake do you think would be reasonable for a general portfolio in a time like this?

Benz: It's a fine line between holding some cash and market-timing. But I would say, if you wanted to take maybe five or 10 percentage points of your long-term portfolio and steer it toward cash in expectations of further buying opportunities, that seems like a pretty reasonable thing to do.

Stipp: The other thing, Christine, is the equity market is a varied market. It's not as if everything in the equity market is overvalued. There can be some pockets of opportunity, and if you choose to tilt your portfolio, you might be able to exploit some of those areas.

Benz: Absolutely. So if you are a stock investor, you can do this yourself--look for reasonably valued stocks. I took a look at our Style Box recently, the price-to-fair value for each square of the Style Box. It looks like the large value square, as is perennially the case, is the cheapest square of the Style Box. Within sectors, basic materials look cheap to our equity analysts, as do energy stocks. On the expensive side would be some of the consumer discretionary names, as well as technology names.

For people who aren't comfortable picking stocks or just don't want individual stocks in their portfolio, I think a perfectly reasonable thing to do in this environment is just to make sure you have some good large-cap value or value-minded fund managers working on your behalf.

Stipp: Your last strategy, Christine, is to look at funds that have a little more flexibility. So in a market where some areas really don't look that attractive, they can choose to invest elsewhere.

Benz: Right. This goes hand-in-hand with making sure that you have some sort of a value-oriented portfolio manager working on your behalf. I think that right now it's a particularly good time to have a fund with a flexible mandate, where perhaps the manager can raise cash for you, if he or she isn't finding good things to buy, or maybe venture overseas. A couple of funds that fit the bill: one would be FPA Crescent. There's been a lot of enthusiasm for this fund. We've seen investor dollars flow into it, but I still think it's certainly a fund that puts safety-consciousness first. Wintergreen would be another idea of flexible, value-minded manager. Another flexible, value-minded global manager would be the team at Tweedy, Browne Global Value.

Stipp: Some great tips, Christine, for pretty fully valued market right now. Perhaps the most important thing is to just expect the market, being fully valued, could maybe have a correction at some point or another.

Thanks for joining me today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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