Tue, 21 Jan 2014
Roundtable Report: At the outset of 2014, Morningstar strategists dig into the market's current valuation and expected return, seek out high-quality U.S. and foreign stock opportunities, size up the role of cash today, assess the Fed's impact on the market, and reveal the best ways to fight inflation.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.
Investors enjoyed a more than 30% return in the stock market in 2013. I'm here today with four Morningstar newsletter editors to see if any major changes are needed to portfolios for the New Year.
I'm joined today by Sam Lee, the editor of Morningstar ETFInvestor; Russ Kinnel, director of mutual fund research and also the editor of Morningstar FundInvestor; Josh Peters, our director of equity-income strategy and editor of Morningstar DividendInvestor; and Matt Coffina, the editor of Morningstar StockInvestor.
Gentlemen, thanks for joining me today.
As we enter 2014, the biggest question all of you were probably asked over the holidays by friends and family is, after this 30% run in the S&P 500, are U.S. equities just incredibly overvalued? Is this a time that people really should be cutting and running?
Matt Coffina: I don't think the market as a whole is all that overvalued. If you look across Morningstar's coverage universe, the median stock is trading at about a 4% premium to our fair value estimate, which actually hasn't changed that much since the beginning of the year. And the S&P as a whole is trading at about 18 times trailing operating earnings, which is high by historical standards if you look over the past 100 years, but it's basically in line with the average of the past 25 years or so, when multiples have been higher relative to the prior 75 years.
That said, I think there certainly aren't the same level of opportunities we saw several years ago. To a certain extent, I think investors have become spoiled by the great valuations that were available in 2008-2009 and even into 2010 through 2012. Right now, we are looking at a much more fairly valued market, which I think over the long run can still deliver total returns after inflation that are somewhere in the neighborhood of 4% to 5.5% a year, which would be a little bit below historical standards. Historically the S&P has returned more like 6.5% a year after inflation. But it's still far better than you are going to do with bonds yielding 3%.
Glaser: Does that range of returns makes sense to all of you, or do you have a different thought?
Sam Lee: I'm on the lower end of the camp. I think 4% is reasonable. That kind of makes me a black sheep at Morningstar, but I'll explain why.
I think, historically, per-share real earnings have generally grown at a rate of about 1.52% per annum over the past 100 years, and right now the S&P 500 yield is about 2%. So if you add in maybe 0.5% for net share buybacks, you're looking at about a 4% real return.
I think a lot of the return that has come over the past 30 years is because interest rates have collapsed, so discount rates have collapsed, and therefore stock price/earnings multiples have collapsed. So lot of the returns that we have experienced over the past 30 years is sort of due to one-off capital gains due to this compressing discount rate, and I don't think investors can rely on that. I think that will actually be a headwind going forward, because when interest rates rise, the market is going to discount future cash flows at a higher rate, therefore making it less valuable today.
Josh Peters: I feel odd being cast here in the role of optimist relative to some, … It's very true. The rise in the P/E multiple of the S&P 500 last year accounted for more than half of the total return. That was a big change. But I don't think we ever got in the post-'08 and '09 environment to the point where those super-low interest rates were really being discounted in the equity market. They certainly we are in the bond market, where everything just trades mechanically off of benchmark yields like the 10-year.
But on the equity market, I think the big variable is, you do have still-low dividend yields. Historically you've had, relative to what people would expect, slow growth in earnings per share and dividends per share. But I still see a lot of potential for Corporate America to pay out, to raise that yield, without necessarily giving up the underlying growth potential.
And that's one of the things we've seen here in the last couple of years is that the payout ratio, the proportion of earnings being paid out as dividends, is rising. Now, it needs to rise more. Historically the market would have a yield of, say, 3.5% or 4%, giving you a much better overall total return basis from that point. But I think corporations are starting to figure it out. The more we move into this age where baby boomers are retiring, relying on their portfolios for income, especially the equity piece that generates that real return, more companies are going to have to pay up.
So in that case, as long as corporate profit margins hold up, I think you could still over a long time period--10, 20, 30 years--look at getting historically normal, 6%-type real returns, maybe 8%-9% with inflation added in. But getting dividends back on track is a very, very big part of that formula.
Glaser: Russ, what are the U.S. equity managers saying? Do they see this 4%-6% type of range, or are they more pessimistic or optimistic?
Russ Kinnel: At the pessimistic end, GMO is forecasting negative seven-year returns after inflation for most U.S. equities, except for high-quality. They like Europe and emerging markets a little better. So they would be at the pessimistic end. Others are more optimistic than that.
I don't have lot to add myself on valuations, but I would say to your earlier question, should people bail, I don't think so. But I think you need to curb your enthusiasm and be fairly cautious. Think about defense, because the last time we had a 30% gain in the S&P was 1999, and we know what happened after that; it wasn't pretty. I'm not saying the next three years are going to be a horrible bear market. Just that you want to think about defense, too.
Glaser: For somebody who is worried about another 1999 or 2008, at what point do valuations start ringing alarm bells and you would start thinking about selling into cash or thinking about becoming much more defensive? What kind of run would we have to see from here to get to those kind of levels?
Lee: I think no one should ever go into all cash from equities. That's a very dangerous game to play. Because, number one, you don't know if you are actually a good market-timer or not. Market cycles go for anywhere from five to seven years, and there are only so many market cycles in your lifetime. So it's hard to get a statistically significant sample as to whether you are a good market-timer. Studies say most people can't market time, so you shouldn't even bother trying it. Even if valuations are a little high, corporate earnings, I think, will grow into them. So if you hold on to equities, you'll do fine over 10, 20, 30 years.
Glaser: Russ, you mentioned being somewhat defensive today. What mangers do you think, what funds, look more defensive right now, like they are being positioned in a way that's going to provide better returns and aren't taking too many risks?
Kinnel: There are funds that have a fair amount of cash, like Longleaf Partners, or the freshly closed Yacktman Funds have been raising cash. FPA Crescent has got a fair amount of cash. And then you have funds that just tend to buy more defensive stocks, like Jensen or LKCM Equity, which I like a lot but that's been overlooked. It's got some high-quality names, but it's also valuation sensitive. Historically those are all funds that tend to hold up better in a down market.
Glaser: How about for individual stock investors? Are there certain sectors people should be looking at? Certain types of stocks? What looks reasonably attractive right now?
Coffina: In the current market, rather than cash, I think there are some more conservative pockets of the equity market that look relatively attractive. Certain very high-quality stocks that aren't necessarily getting priced for the quality that they have and that are on track to deliver total returns at least in line with the market with much less risk overall.
I would think of sectors like consumer defensive, utilities, real estate investment trusts, pipelines--a lot of these sectors are looking relatively attractive right now. They've really been out of favor ever since May when the Fed started with the initial talk of tapering the quantitative-easing program. Some specific names that come to mind would be, for example, Coca-Cola and Unilever in the consumer defensive space. I think both companies are on track to deliver 8% to 10% total returns with less risk than the overall market.
A real estate investment trust that I recently purchased for [Morningstar StockInvestor's] Tortoise Portfolio was HCP. It's health-care focused. The stock yields about 5.8%, and they can raise their rents every year by, call it 2.5% to 3.5%. So I think you are looking at a fairly easy 8% to 9% total return on the base business, again with lower risk than the S&P as a whole.
One more name to throw out there would be ITC Holdings. That's a utility that, again, has above-average growth prospects, a slightly higher multiple than the utility space as a whole. But I think it deserves that, because of its better growth projects in the pipeline.
Peters: I think the answer to that question really comes down to the individual investor, and what he or she is trying to accomplish. I went through a year where, early on owning those defensive names, those higher-yielding names, it was very good. We were beating the market in both portfolios I manage through May. Then the Fed started talking taper. The economy seemed to gather a little bit more strength. Cyclicals took off, speculative stocks took off, and a lot of those more conservative names got left in the dust.
What did you actually lose? At the end of the year, both of my portfolios, even though they had fallen behind the S&P for 2013, were at new highs, had excellent income growth for both portfolios during the year, and we did it with a lot less risk. We can't really measure that risk in terms of standard deviation or beta. It's very hard with those backward-looking statistics to get a sense of the risk you are taking. You have to think, does this company hold up well in a recession--because I don't know when it's going to happen.
I don't try to time the market, like Sam said. I think I'd be absolutely terrible at it. Trying to time sentiment shifts is an even more complicated game for most investors to play. So what I think you do is, you stake out your ground: What am I trying to accomplish? In my case, it's trying to craft a stream of income from a group of stocks that can pay and raise their dividends through all kinds of environments, and then you stick with that.
The last thing you want to do, after a year like 2013 where the overall market did really well, maybe your more conservative stocks didn't do as well, and people in the social networking hot stocks or a Tesla are getting rich--you don't change strategies at that point in the game.
If you wanted to circle back with 20/20 hindsight to the middle of 2012, when the cyclicals were cheap, well maybe that was the opportunity to buy them. But right now that opportunity is pretty much gone. You stay with the strategy consistently through whole market cycle, multiple market cycles. In this case, my case and my strategy, I let the dividends do the heavy-lifting and don't worry so much about the relative performance, or what is necessarily going to outperform just in the next year.
Glaser: Sam, you mentioned looking at conservative stocks versus cash, but is there a case for holding a little bit more cash than usual right now? What would some of the benefits and some of the drawbacks be of having a bigger-than-average cash position right now?
Lee: I can talk about that. I have a pretty hefty cash stake, but it's not from equities. I have actually taken my cash out from bonds. The individual investor can get about a 1.5% yield from certain high-yield bank CDs. So there's no real need to actually stretch out onto the credit curve or the yield curve to pick up a little bit more incremental income. You can actually get perfect safety and a high level of liquidity just by owning these high-yield bank products.
I think in relation to bond funds, which are priced to earn about zero to negative real returns, and they are going to take on more risk, I think cash is a no-brainer for most investors. I don't think it makes sense to own a lot of these newfangled, short-maturity, "safe" bond funds or income funds.
Glaser: Russ, how do you think about cash?
Kinnel: I think there is some value to it. I wouldn't raise my cash position a lot, but I think, there is certainly some value there in terms of having some dry powder for the next sell-off. A little bit of cash is valuable, and you have to look beyond the fact that if you're in a money market, you are getting more or less no yield. If you are doing Sam's approach, you get a little more, but either way you are not getting a ton. But the point is simply you've got a little dry powder for the next sell-off, and I think that helps your mindset, too. You will think about the opportunities, rather than if you're fully invested [during a sell-off], you might be thinking, I've got to cut my losses.
Glaser: We've been talking mostly about U.S. equities. When you look abroad, are you seeing more values? GMO is a little bit more constructive on European stocks and think they are going to do a little bit better. Does that seem to hold across the panel? Do you think that there are opportunities outside the U.S., either in emerging or even developed markets?
Kinnel: I am certainly hearing a consensus of the managers I've talked to that they still think Europe is the best bargain out there. Like the U.S., Europe had a really great year in 2013, so it's no longer a screaming buy, but a lot of people are saying, it wasn't too long ago that we had priced in some pretty severe crises in Europe, and so a lot of people think that the economies will generally improve in Europe, and they think there are better deals in Europe than in most other places.
Glaser: What are some of the better Europe-focused funds right now?
Kinnel: Well, I like some of the foreign funds that are not officially dedicated to Europe, but can invest there, and invest heavily. Causeway International Value is a really good fund that is about three quarters in Europe. USAA International is run by MFS, and that's about 70% in Europe. They're really good low-cost funds with excellent strategies and management. I think those are among the best plays. If you want a pure-play, you can go with something like Vanguard European Stock Index.
Glaser: Sam on the ETF front. Do you see any value in Europe or in other markets right now?
Lee: Definitely. If the U.S. is priced on the slightly expensive side, I would say foreign markets, especially emerging markets, are priced more on the fair to cheap side, especially when you consider the fact that over the past three years, emerging markets have lagged the U.S. market tremendously.
The valuation is very simple, in that if the price of something rises a lot, it's more expensive and therefore its future expected returns are much lower. And the converse holds true: If the price falls or lags, then its future expected returns are much higher.
So, I think a lot of investors would do well to shift more of their equity exposure to emerging markets and [overseas] developed markets, especially because a lot of investors today already have a home bias. They tend to overweight U.S. equities, and I don't think that's necessarily justified.
Glaser: What are some emerging-market funds that that would be a good choice?
Lee: I am a plain-vanilla guy. I think Vanguard's developing market and developed market Funds are good. Vanguard FTSE Emerging Markets, ticker VWO, and Vanguard FTSE Developed Market, ticker VEA, are two excellent funds from which you can form a core international equity portfolio.
Glaser: On the dividend side, are there companies outside the United States that you look at for that yield? What have the dividend policies been like outside the U.S. over the last couple of years. Have they also been trying to return more cash to shareholders?
Peters: That's been a phenomenon for a very long time, and it wasn't really the rest of the world that changed; it was the U.S. that changed. [In the U.S.,] the payout ratio slipped, dividend yields came down; investors here in America seemed more interested in growth in capital gains. Elsewhere, that wasn't necessarily the case.
So what you sometimes can find are bigger multinational companies, like Glaxo, which is pretty similar to a Johnson & Johnson, or a Unilever, which is pretty similar to a Procter & Gamble. But the dividend policies are a little bit more generous. Those are two names that I bought during 2013 that I was happy to pick up.
I get a little bit of currency risk [with those names], but they are both British companies, which means there are no withholding taxes if you own these stocks and are collecting the dividends in an IRA. You are getting plenty of global exposure, but you are also gaining maturity. You are not making an income bet on some tiny emerging-market company that may or may not be around to pay that dividend. My standards for foreign companies are certainly no lower than they would be for domestic ones.
To the extent that it opens up a broader opportunity for you to add new companies to your portfolio that have those same yield and dividend growth characteristics that you'd look for here [in the U.S.] … I added more to those foreign stocks in 2013 than I did to domestic ones. It's not a huge part of our portfolios, but one that we're happy to take advantage of.
Glaser: Matt, you own Baidu, which is kind of a Chinese Google. Is that just a pocket of opportunity you see in China, or do you think that there are more opportunities there for investors to be eyeing?
Coffina: Similar to Josh, I never go out looking for exposure to a particular international market or an emerging market. It really comes back to the bottom-up fundamental research and where those opportunities are. We'll take those opportunities wherever we can find them.
One that we took advantage of in 2013 was Baidu; it's actually appreciated to be the biggest position in the [Morningstar StockInvestor] Hare [Portfolio] right now, but it's really no longer trading at an attractive discount to fair value, and it would be difficult to recommend adding new money to Baidu now. I'm willing to hold the stock, because I think the growth outlook is still very robust and very long-lasting. But there isn't the same margin of safety now as there was when we first purchased.
Other than that, our main international holdings are more the multinational kind of companies that, maybe they're based in Europe, but they are really not substantially different than similar multinational companies in the U.S.
An example would be Nova Nordisk; it's a diabetes-focused specialty pharmaceutical company, and I think the valuation is relatively attractive. But really it has nothing to do with the fact that the company is based in Denmark. It's just a very high-quality pharmaceutical business, and they do business all over the world, including in the U.S. and in emerging markets.
Similarly, we own Novartis, but we also own Philip Morris International, normally considered a U.S.-based company, but they don't do any business in the U.S. at all.
I think you can get your international exposure from all sorts of places, and it really comes down to whether the individual company is attractive, the valuation is attractive, the competitive position is strong, and so on, and we'll take those kinds of opportunities wherever we can find them.
Glaser: So if we're looking at somewhat average returns or below-average returns for the next couple of decades, potentially, is that a case that stock-picking is more important, and investors might want to think about either individual stocks or active management versus indexing? Or is that really going to be a matter of personal style? Do you have a sense of what's going to make sense in the time to come, versus what's worked over the last few years?
Lee: I think in this case if you are a good stock-picker, you should be exercising your skills. If you are not a good stock-picker, it doesn't make sense to go into the stock-picking game just because yields are low, prospective returns are low, and therefore you are going to try to achieve an income target or a return target by exercising, maybe, your stock skills.
Generally, if you have an advantage, you exercise that, and if you don't have an advantage, you don't go out and try to create one without good justification. So I would say, most investors should not be trying to move beyond their circle of competence.
Kinnel: I'm not a big believer in stock-pickers' markets. I understand there are times when all stocks move in lockstep, and other times when they differentiate more. But for the most part, I feel like you see the same number of active managers outperform every single year when you correctly adjust for the right index rather than comparing them all to, say, the S&P 500. So I'm not sure I believe in stock-pickers' markets, and I certainly am dubious that you can predict that. I am a little skeptical about calling the right time when you should switch from active to passive and back.
Glaser: So if someone had active managers now and was happy with those active managers, there shouldn't be any reason to walk away, or vice versa, for indexers to switch.
Coffina: I think there is something to be said, in a market that has less-robust long-term total return potential, for focusing your stock-picking. We've seen this a little bit in the history of the [Morningstar StockInvestor] Tortoise and Hare [portfolios], where we've experienced our greatest outperformance during the down years. That's because the kind of companies that we own are the kind that consistently compound their intrinsic value over time.
I have a high degree of confidence that most of our firms, five and 10 years from now, are going to be worth substantially more than what they are trading for today. And if they're not trading for substantially more five or 10 years from now, then they are going to be very cheap at that point, and we'd be still happy to continue owning them.
I can't say the same with quite as much confidence about the S&P. The earnings growth outlook for the S&P is much harder to predict than it is for some of these very high-quality, competitively advantaged firms. So, it may be the case that the S&P delivers comparable returns, or it may not be, but focusing on intrinsic value and companies that can compound their intrinsic value, call it 8% a year, I think they'll do very well over the course of a five-, or 10-, or 20-year investment horizon with a greater level of confidence than just investing in the market as a whole.
Glaser: The Federal Reserve was the big story of 2013 in a lot of ways. They started to taper in December. We'll probably be hearing "taper, taper, taper" through all of the [Fed's] meetings throughout 2014.
How much should investors care about this? Should they be focused on whether they are going to take $10 billion out this meeting? Are they not going to do it at this meeting? Is this just a lot of noise, or is it going to have a real impact on decisions that you should be making?
Peters: I'd say 90% noise, maybe. You have to cast it in terms of your time horizon. If you are actually going to stick with a portfolio strategy consistently over a series of many years, then you should never have assumed that interest rates are going to stay super low in the first place. That was something that I tried very hard to avoid as I was picking stocks that have high yields. I wanted to make sure they were priced appropriately for a more-normal level of interest rates. But the circus we have now around every Fed meeting, now the dam has broken, the taper has begun, and it will be $5 billion, $10 billion, $15 billion … will they put it off?
Matt made the point to me earlier this year. Will it make it any difference if they do it now instead of six weeks from now? Will anybody remember five years from now? It really does wash out. You do have to think on those longer-term average bases. I think not so much about the journey, but the destination. I figure a 10-year Treasury yield that is in a normal range is probably in a 4% range, maybe as much as 5%, but probably 4%. That's a normal 2-point spread to inflation, plus about 2% inflation.
You don't want to buy any stock that's priced for a yield lower than that, but if you can buy stuff right now like one of my very favorite REITs, a longtime holding, Realty Income. Lately the stock's yield has been around 6%. That's giving you a pretty good cushion against these interest rate increases that I'm almost sure are coming. People say, how can you buy this REIT when you think interest rates are going up? Because it's already priced in. It doesn't mean that the stock is going to knock everybody's socks off as rates are rising, but once you get to that destination, I think you'll still have had a good total return, and you'll have enjoyed the income and the income growth in the meantime.
Lee: I would say that it's actually worse than noise to pay attention to this taper talk, because most investors don't have a competence in predicting the moves and the impacts of those moves at the Federal Reserve. So if you're going to time your exposures based on the timing of the Federal Reserve's interest rate moves and purchase moves, then you are going up against very tough competition. You have people at PIMCO sitting around all day--math geniuses, economists--trying to anticipate these. They are doing detailed modeling of each individual Fed decision-maker. And you have the news, the public news.
So the typical investor doesn't have any advantage whatsoever. I would say that they probably have a negative expected return from trying to time these moves. Because if you are a typical investor, you are probably going to be thinking in a very typical manner, and you are reflecting common knowledge and common wisdom, and more often than not, that's wrong. So you're probably going to be on the wrong side of these trades. I would say, stay away from thinking about the taper.
Kinnel: I think Fed news is … it's useful to understand what's going on in the market; it helps to put it in context. But as everyone is saying, I don't think you want to try and let that drive your portfolio or think that you can out-pick Bill Gross and rate calls or anything like that.
Coffina: I'd just add to that: The time to worry about this was about a year ago--not so much now. We've seen our stocks that are positively exposed to higher interest rates--companies like Charles Schwab, Automatic Data Processing, Paychex--these have been some of our best performers in 2013.
The kinds of stocks that you'd expect to be hurt by higher interest rates, like REITs HCP or Realty Income, for the most part, those have already been among the worst performers in 2013, and if anything, they are already priced for much higher interest rates than we have right now.
So I think it would be very backward-looking to focus on the Fed's taper, because the market has been expecting this since May at this point, and the time to worry about it was before May. January-February of last year, not now.
Kinnel: I was really struck by how we saw a lot of outflows from bond funds, the core high-quality bond funds, this summer and continuing throughout the year, because when the interest rate picture changed and rates started going up and these bond funds started getting hit, people were surprised. And it's kind of funny, because if you go on Morningstar.com or anywhere else, we've been talking for years about how this was going to happen--not that anyone knew exactly when--but I think unfortunately too many people may have just been watching the fund returns and were caught off-guard despite the really long lead time on it.
Glaser: So if the taper was the thing to be worrying about a year ago, what's the thing this time next year that we're going to say, oh, we should really have been worried about "X"? Is it something from the Fed? Is it something we don't know about yet? What should be on the radar now?
Lee: If I knew, I'd be a billionaire.
Peters: I've been thinking about this all week, and I can't come up with something.
A year ago--we came into . We'd just gotten through a big controversy in Washington. We had the fiscal cliff and all the rest. Well, that's kind of gone away. I don't have to worry so much, perhaps, about the headwinds from fiscal policy at this point. Europe now seems to be turning the corner very, very slowly, but it doesn't seem as crisis prone as it was before.
There is lot to be comfortable about. You can come up with the wild hypotheticals of things that would go wrong, and that's probably what will happen. It will be some wild hypothetical that will turn into the big problem that we haven't thought of yet.
I would actually rather have a little stockpile of things I know the market is worried about, because then it's probably priced in. When you're trading at 17-18 times earnings, as we are now, then you don't have that cushion for the unexpected. You need the economy to continue to perform well, or you're probably going to get some kind of blow-back in the market. So that's one of the things to be prepared for.
The best I could come up with is, the one thing I know I'm not expecting is an average return--because I went back and looked, and over the last 85 years with the S&P 500, not once has the annual return fallen between 9% and 10%, which is what everybody thinks the average is. Average is the one thing you should rule out on Jan. 1, every single year. There'll be some volatility. You prepare in advance for it with portfolio selection.
Lee: I would say, though, one potential risk is more behavioral. We've had a really good runup in the market. I see a lot of investors who have been sitting on a pile of cash who are now going into the market. Well, the time to go into the market is when prices have declined a lot, not after they've run up. It's classic return-chasing behavior.
And also, the market seems to be now accepting that the Federal Reserve has control over interest rates, and that they have everything at hand, and that the Federal Reserve is all-powerful, and all-knowing, and that Ben Bernanke and Janet Yellen will protect them. And I think that might actually be surprising.
I would say that most investors should be slightly defensive in that they should not bet on risk assets continuing their tear going forward, and they should not be relying on their retirement plans earning 20%-30% in the next year.
Glaser: But in terms of what the Fed could let get out of control--could it be that interest rates rise faster than expected or inflation gets out of control? Or is it just one of those things we don't know?
Lee: It's one of those things we don't know. A lot of people don't understand that what the Federal Reserve is doing is still highly experimental. There's a lot of uncertainty. These are academic theories that are being put to the test in real life, and so far they've passed with flying colors, but we don't really know going forward. So, I think that's a risk that maybe you should be somewhat cognizant of.
Glaser: But generally speaking, it seems like you still expect rates to continue rising, maybe not at the clip they did it in May, in that step function we saw then, but would you think that rates could keep rising? And what does that mean for, particularly, bond investors?
Peters: I'm inclined to think that rates will continue to rise if you're thinking about a two-, three-, or four-year time horizon. But one of the things that's going to be very interesting--I can't really predict--but I think is going to be very interesting to see how it unfolds in the next year or two is how much higher can rates rise before you start seeing some sort of dampening effect on the real economy?
A year ago, I was able to refinance my mortgage at 3.5% on a straight 30-year mortgage. I don't know if I'll ever be able to move now; I have this awesome mortgage. Now they are 4.5%. The 10-year Treasury has gone from sub-2% to about 3%. If long-term interest rates go up another percentage point, and 30-year fixed-rate mortgages go up to 5.5%, does that just stop the housing recovery in its tracks?
I think you have to think ahead a step in that the Fed, to the extent it can control interest rates and manage this process, they are going to try to, but even if they have some loss of credibility, if the process goes too far, or if rates rise too fast, my guess is the economy slows down and rates fall back. There are going to be self-adjusting attributes to this process, and I think a lot of people actually overstate the impact that the Fed has had with its programs. They are trillions of dollars. It's huge. But how much has it really mattered and really changed the economy? The economy has been weak for lots of reasons that have nothing to do with the Fed. It seems to be getting better now; maybe that has nothing to do with the Fed, either.
Glaser: But if rates are to keep rising, if you are a bond fund investor or a bond investor, does that mean you should stick with short duration? Should you be taking credit risk instead, and avoiding some of the long bonds? Or is this really priced in at this point, and your allocation should maybe look like it has in the past.
Kinnel: Interest rates are still very low relative to history, and so I think there's certainly still a fair amount of risk in longer-term bonds. It's interesting, Bill Gross and Dan Fuss, two of the best bond managers out there, are both saying, get on the short end of the yield curve. That would certainly make me a little wary of being out at the long end, but again I wouldn't drastically overhaul my portfolio.
I suppose if you had a lot of long-term Treasuries, well, you just had a really bad year. I suppose you could sell a little. The market has corrected some of that for you. So maybe you cut a little, but I think generally there is still a fair amount of interest rate risk out there.
Lee: I would say the extremely long-duration bonds are not being owned by professional investors. They are often being owned by non-price-sensitive economic actors--pension funds, insurance companies--that need to hedge a long-duration liability. So a lot of this demand at the long end is being soaked up by investors that don't necessarily care about the economic rate of return; they are going to get on the bond, because it offsets some risk that they have.
I think the consensus that long-duration bonds are somewhat dangerous is right, because if you're right [in owning long-term bonds], you are going to get a couple of more percentage points a year. If you are wrong, you are going to lose your shirt. So, I would say that most investors can reasonably make a case of staying low or short duration.
Glaser: For retirees who are looking for income, the rising rates might be somewhat of a relief. What does this mean for a lot of other income-producing securities, from REITs and MLPs to bond funds? How should retirees think about that income portfolio? Are there any changes that they should think about making, or is it already too late, and a lot of it has been priced in already?
Peters: I think you want to think about real return, and you want to think about getting a growth component even from your income investments. I wonder why anybody owns long-dated bonds. Sam made a very good point. There are a lot of people who are not necessarily sensitive to price who are forced on these things, but should 10- or 30-year Treasuries be the core of the average retiree's portfolio if that money is committed and in place for an indefinite time horizon? I'd say probably not.
There's some advantage to having it as a volatility dampener, but beyond that, I think you want to look for equities that are capable of paying and maintaining very good dividend payments even in the down times, and then growing those dividends and providing some basis for capital appreciation in the better times. I think that's really what is the best core of most retirement portfolios, that you get that real return component. Without it, then you are just making an interest rate bet.
Sam Lee: I would say that in terms of income portfolios, a lot of investors don't realize that income isn't necessarily real income. Sometimes it's the return of capital. A lot of products out there promise high income, but what you are getting is just return of the money that you've already put in. So you have to be very careful about where that income is coming from.
A lot of the highest-income products and stocks out there are some of the most dangerous, because they take advantage of these investors who are just mindlessly looking for income. So, Josh is absolutely right. You have to look at the growth component. A lot of times investors think of income as the goal, but I see income as a signal of quality in an asset. If the quality isn't there, then that income isn't necessarily attractive.
Kinnel: Christine Benz has written about the total return approach for income, saying that, yes you want income, but if you're getting returns, you can also harvest some of that out of returns. Last year at this roundtable we talked about how chasing yield is one of the biggest risks you can take, and that's still true today.
I think there are some European equities--Josh mentioned a couple--that have a decent yield, and I think you can find some European equity funds that have a decent yield. That's one of the places where it's maybe a little underappreciated. But we've been wringing income out of the system for a while now, so every step up in yield is generally going to be a step up in risk. You've got to be careful.
Glaser: What is that level of yield that you might see as a red flag that you are really taking on a lot risk? What's a number that might stand out to you?
Lee: Anything above 10% is pretty suspect. Often you are going to get it from leverage. It's very rare to find something that yields 10% that's actually safe and is going to be reliable. So I would say 10% is a warning sign, but you can't really just put a threshold. 9% doesn't mean it's safe. You have to actually look at the underlying drivers of that income.
Peters: I agree. It's dynamic. It changes over time. What I think in the U.S. equity market as the "sucker yield" threshold--beyond this point, do not cross; this is where there's a lot more trouble than it's worth to take--I'd probably put that around 8% right now.
There are some stocks like Windstream, which now yields 13% give or take, the highest-yielding stock in the S&P 500. That is just screaming, "dividend cut candidate." Management doesn't want to cut the dividend, but the old, classic telephone business is in decline, and they may not have much of a choice. They've got a lot of debt on their balance sheet.
The only stock that I can think of that has a yield anywhere near that range is AmeriGas Partners. The yield has been in the 7% range lately, and I think it's just a misunderstood and ignored name in the MLP space. It's a very boring business compared to the sexy stuff, like hauling crude oil. They're a propane distributor. There is some variability in the weather, but the weather averages out over time. They've got a very good business model. They own their customers' tanks for the most part, so they can push through price increases pretty easily. It generates almost-clockwork-like distribution growth of 5%.
So there you're getting a lot of yield and you are getting the growth, too. You're getting the income and you are getting, like Sam said, the signal that there's more quality in the business than the market is giving it credit for.
Other than that, nothing with a yield in that range or higher is something I would look at as being attractive right now.
Glaser: So always do your homework?
Peters: Oh yeah.
Kinnel: On the fund side, I would say, within a category, you can look at, what's this Vanguard fund's yield, and then compare it to another fund's yield, because the Vanguard fund is going to be cheaper and it's going to be fairly conservatively run. So, if you are looking at a fund in the same category that's got a yield 50% above that, it's probably taking on significantly more risk--probably credit risk. If it's two times that, you know it's a pretty big risk. That's another way to benchmark the risk level of the fund.
Lee: I would point out that certain funds that seem to have a high yield are actually earning that yield in different ways. Funds that use a lot of swaps tend to support very high yields, but that income is actually just another form of capital appreciation. There are certain closed-end funds that have extremely high distribution yields, but either they are returning capital or they're spinning their income through swaps. So it's basically another form of capital gains. It's really no different than just getting straight-up equity exposure in those cases.
Glaser: Inflation is one thing that no one has mentioned as a particular concern, and it seems like the Fed is not particularly concerned--at least on the upside; maybe they are a little bit concerned that it's below target.
Are there any worries about inflation eating away at portfolios, either in the medium term or the long term? Is there anything that people should be doing to position their portfolios to protect against this today?
Peters: I was prepared to bring it up if nobody else did. I think it's the number-one threat, especially for more conservative, more income-oriented investors. You have to guard against it. You have to think about it, even when there's not a lot of inflationary pressure out there. Right now, though, I just don't see any.
CPI lately, year-over-year, has been in the low-1% range. I think the Fed has had some concern that deflation may be as much of a risk as inflation getting above target. They have said they are willing to let it run a little bit above target for a while, if that will help support the economy growing a little bit faster.
I break it down into labor and commodities. We had a huge commodity boom that encouraged a ton of investment. We are now seeing the production start to roll in globally in a lot of commodities, and you are not seeing the big runup anymore.
And on labor, this isn't the 1970s. You don't have the institutional structure in place to get that classic wage-push spiral. A company raises prices, raises the cost of living. Unions ask for a big wage increase and they get it, because the company can just push through another price increase.
In the United States or anywhere in the developed world, the economy is just not the way it was in the '70s anymore. It's much more competitive, much more productive, and labor just doesn't have the clout to push through a lot of cost increases that lead to inflation.
So I worry about it, and I look for hedges wherever I can find them. I think your number-one hedge is to get an economic-moat-protected business that should have some pricing power and the ability to earn a good return on capital over time. I want to look for it, but I am not seeing that inflationary pressure out there right now.
Coffina: I would largely agree with Josh that people have been worried about inflation for years with all of the Fed's extraordinary monetary policies, and we haven't seen it yet. We don't really see any evidence right now.
But I don't think inflation is dead for good, and when it comes around, people are going to react very quickly to that, and there really won't be time to adjust. It will be too late.
I think inflation is something that you need to worry about all the time, particularly if you are trying to meet real-world financial needs. We don't really invest in any company that I don't think has a fair degree of inflation protection, which again comes from having a competitive advantage, being able to raise your prices at least in line with inflationary levels.
Even investing in things like REITs, I would focus especially on REITs that have inflation adjusters embedded in their leases. The longer you have the lease term, the more important that becomes, or have the ability to raise their lease rates over time to keep up with inflation. Certainly, fixed-income investors are going to be the worst off if we do see a return to inflation at some point. Again, I think equities and high-yielding equities, are the best hedge against that.
I would agree with Josh that I can't really understand why anyone would own a 10-year Treasury yielding 3% when you can buy a company like Coca-Cola or Unilever with a comparable yield, growing at least 5%, 6%, 7%, and probably more like 8% or 9%, a year. You get the inflation protection and the comparable level of income. And if you don't need the principal in the near term, there's really no reason that you should own a long-term bond.
Lee: I think inflation is a risk in the long term, and it's always been a risk in the long term. There are very few instances where a sovereign that has racked up a huge amount of paper debt is going to pay it back in full. Their incentive is to inflate away. If you actually look at a globally weighted basket of bonds held from 1900 all the way until 1980, your total return would have been close to 0% after inflation, and these are high-quality sovereigns like the U.K., the U.S., France, Italy. And over that period, these winners of the 20th century, their bonds basically kept up, just maintained parity, over 80 years. It's only from 1980 and on that the worldwide global sovereign paper market actually produced substantially high real returns.
The last 30 years are a bit of an anomaly. Historically, sovereigns have inflated away their debts, and I think that's something that you should worry about 10, 20, 30 years from now, because there's so much debt in the system that, rationally speaking, you want a sovereign to actually inflate away, because if they don't inflate away, it's going to impose a huge burden on the real economy. For that reason, I agree that you should stay away from long-duration bonds.
Right now, inflation is not a worry, and I think there are some people who say that inflation is such a worry, that inflation is actually here, and that the government is manipulating the statistics. Well, there is really no evidence of that, because if … inflation was manipulated 2%, GDP growth over the past 30 years would've been basically zero, and that's clearly not the case. It's very implausible that inflation is being manipulated. It's actually pretty low right now.
Glaser: If you're worried about inflation, though, and you are trying to guard against it, what about the alternatives--things like buying commodities, getting into gold funds, or other alternatives that are being marketed out there? Is it really just marketing, or is there any substance to some of these non-traditional strategies?
Kinnel: I think commodities funds are certainly a good way to hedge some inflation risk. But as you can see from the 2013 returns, there is a downside there--commodities are very volatile, and when inflation goes down, commodities will go down a lot. So if you do invest in commodities funds, you want to keep it a small part of your portfolio. It's a useful hedge, especially if you have a big chunk of your portfolio in bonds.
TIPS also had a bad year. They are more about protecting against interest rate hikes. Again, there are some decent protections there, but I would still keep it fairly small. I think people were surprised about the losses that hit TIPS--Bill Gross included.
Coffina: I think as we saw with gold in 2013, the short-term sentiment-driven changes in commodity prices can overwhelm any kind of inflation hedge over any realistic investment horizon. Gold lost enough in 2013 to offset maybe 30-plus years of inflation at current rates. So, I would much prefer a competitively advantaged business--something like a Coca-Cola or Philip Morris International--that can steadily raise their prices every year to at least keep up with inflation, and in that case they can preserve their real earnings power and the cash flow potential to investors.
Lee: Gold is an interesting example, because it's held out as an inflation hedge, but historically its returns have been largely driven by changes in the real interest rates. So gold's fabulous run over the past 10 years or so was largely the result of interest rates falling--real interest rates falling--and that, if you notice, gold has done terribly as interest rates have risen.
So, gold is really a bet on declining or low real interest rates. A lot of people don't realize that, which is kind of funny. A lot of inflation hedges have inadvertent bets embedded in them that a lot of people don't understand.
I would say plain-vanilla equities are probably the best inflation hedge, in that they'll do poorly if inflation suddenly surges, but over the long run--10, 20, 30 years--they will preserve your wealth and very likely grow it.
Peters: Or you can just spend the money right away. A very smart guy, Gerald Loeb, way, way back when, said that was the number-one way to preserve the purchasing power of your money: go and spend it. Other than that, everything is going to have strings attached. But I agree: Plain-vanilla equities, a growing stream of dividend income, and corporate earnings is the best, most effective way to hedge over the long run. Anything else, and you may be speculating yourself into a hedge, and you want to avoid that.
Glaser: It seems like, for 2014, investors really should keep staying the course, stick to their asset allocations, stick to those core, moaty companies and core bond funds, and that it's probably, even with a runup, not the time to try anything too cute, too aggressive, but really look out over that long horizon.
Kinnel: I would say, have a plan and don't get too greedy, especially after a 30% gain. This is the time you should be a little more cautious. But stick to your long-term plan.
Glaser: Matt, Josh, Russ, Sam--thanks so much for taking the time and joining me today.
Kinnel: You're welcome.
Coffina: Thanks for having us.
Peters: Thank you.
Glaser: For Morningstar, I'm Jeremy Glaser.
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