U.S. Stocks: The Only Game In Town

There are a lot of reasons why stocks go up and down, but one of the biggest factors has nothing to do with earnings projections or valuations. It has to do with what stocks are competing against in terms of other investments and right now, the domestic equity market looks like “the only game in town.”

If we assume most investors can easily move their money between investment classes, stocks look awfully attractive relative to other investments.

Cash and cash equivalents including T-bills, money markets and short term CDs pay less than inflation. The world’s central bankers have done everything in their power to discourage holding cash, even briefly charging for the option rather than paying interest. After inflation, cash guarantees a loss of 2.2% a year. If you have an all cash portfolio that is paying out at a rate of 5% a year, you will have lost half your money in real terms in about 10 years. How’s that for punishing savers?

Bonds are generally the place investors turn to when they are driven out of cash. The result has been that yields have been driven down to the point that 10-year treasuries barely beat the rate of inflation. Having to lend money for 10 years just to break even seems pretty unattractive, particularly when the Federal Reserve has all but guaranteed you that interest rates will be going up before long, resulting in a potential loss of value in long term bonds.

One way to boost bond yields without buying very long term paper is to go down in credit quality, but guess what? A lot of people beat you to it. The extra yield you get for the extra risk of junk bonds is near an all-time low, leaving the very real possibility that junk bond investors could get a double whammy of price depreciation from both rising interest rates and narrowing credit quality spreads.

Real estate sucked up an inappropriate portion of investment dollars until investors learned the downside of leveraged real estate in the last financial crises. Despite the fact that real estate investments are subsidized by the government in the form of low mortgage rates and tax preferences; they have significant handicaps in the form of property taxes, upkeep costs, leverage risk and lack of liquidity. Both commercial and residential real estate has rebounded from their lows, but further price appreciation will depend on a much stronger economy and some inflation, both tough things to bet on right now.

Gold and precious metals are the ultimate case of speculators controlling the market. They are the only commodity market that can begin to absorb the trillions of dollars that would make for a viable alternative to stocks and bonds. What makes gold go up in dollar terms is most likely a combination of a weak dollar, inflation and international financial chaos, which explains why gold has been going down for about three years now.

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There is a new asset class that has been the fastest growing over the past couple of decades called alternative assets. It covers everything from private equity funds to forest land; hedge funds to bank loans; long/short funds to net lease back loans. If there is money changing hands, somebody will package it to try to make it an investment. Hedge funds are the biggest part of this asset class, but their performance is less than inspiring.

Hedge funds have made a lot of people hideously wealthy, but their recent performance shows most of the new super-rich were the fund managers, who shamelessly charge 2% of assets and 20% of profits, even while trailing the market. Performance like that has led the California Pension Fund to dump all its hedge fund investments and go back to more traditional, lower cost alternatives. No doubt there are teams of salesmen right now designing the next great thing that promises equity like returns with lower risk, but as CalPERS found out, there is no free lunch, just higher fees!

Emerging markets offer world changing potential, but that doesn’t mean you have to invest directly in emerging markets to benefit from their growth. We own a few stocks based in developing nations, but the markets are too thin and the risks too great to make them a major part of our portfolios. China is balanced on a cliff right now making commodity export oriented economies look vulnerable. With Russian tanks on the boarders of Eastern Europe, Chinese war ships on patrol and Ebola threatening Africa, emerging markets are anything but a risk free trade.

This makes our stock market the most attractive class.

Equities have had the best long-term record of any financial asset and are currently at least normally priced, if not somewhat cheaply priced. S&P 500 big cap yields are about the same as 10-year treasuries before tax, and yield more after taking into account the dividend tax advantage and growth. For investors looking for more income, it is easy to put together a portfolio yielding 3% to 4% and still get good diversity and growth. Growth should come from the continued advance in corporate earnings, now showing six years of steady improvement, and showing no signs of topping out.

Stocks have no maintenance costs, they pay you to own them in the form of dividends. Stocks are liquid, you can sell them in seconds. They enjoy favorable long term gains and dividend tax treatment and they are available in any dollar domination and offer over 10,000 varieties just in the US. They allow you to own the best companies in the world with minimal transaction costs.

There is no substitute for cash if you think you might need the money anytime soon. It lets you sleep at night. We continue to be an advocate for balanced stock and bonds accounts despite today’s near record low yields. Bonds provide predictable income, an anchor to windward in a financial storm and a source of funds to buy market corrections. But clearly stocks offer the best potential reward for long term investors and are currently “the only game in town.”

In the short run the market will trade on the news of the day, leading to the volatility we have seen recently in the market, but over a longer time frame, money has to find a home. Given the alternatives available to investors today, we expect any corrections to be short and shallow, as money naturally flows to where it will get the best return.

Written By: William Matthes