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Still No Alternative

Jonathan Clements, 1:17 am ET

FOR AS LONG AS I’VE been writing about investing—37 years now—grumpy old men have been declaring that the stock market’s party will soon end with a world-class hangover.

Is it time to stock up on Tylenol?

I, of course, don’t have the slightest clue. But when the S&P 500 rises 3% on Wednesday and then plunges 3.6% on Thursday, you sure get the sense that investors are a tad uncertain about the future. That brings me to two questions I’ve been pondering.

Question No. 1: Will we get a wave of panic selling that causes stocks to become unhinged from their intrinsic value? We saw that in early 2020, and also in late 2008 and early 2009. That’s when great buying opportunities occur.

This year’s stock market slump has been dragging on for more than four months, but the decline from the S&P 500’s Jan. 3 all-time high has been relatively modest, just 13.5%. Despite yesterday’s whiff of panic, it would be hard to argue there’s widespread fear, with investors losing all sense of what stocks are worth.

I’ve been adding a little to my stock-index funds at current prices, and I suspect that five years from now I’ll be glad that I did. But I don’t think stocks are a great bargain. Still, with any luck, we’ll get there, at which point you’ll find me buying with far greater enthusiasm.

Question No. 2: Are we headed back to normal historical valuations? Because the U.S. stock market has become so dominated by growth companies, especially tech stocks, valuations will tend to be higher than the historical averages, a topic I’ve written about before.

But the rise in valuations over the past four decades has also been driven by another factor: falling interest rates. If we are indeed seeing at least a partial reversal of the four-decade trend toward lower interest rates, it’s reasonable to think stock valuations will be lower, as bonds offer more competition for investors’ dollars.

The good news: Stock valuations are already looking much improved, with the S&P 500 stocks closing yesterday at just under 21 times trailing 12-month reported earnings. If S&P Global’s analysts are correct in their earnings forecasts, stocks are now at 19.1 times 2022’s reported earnings and 17.1 times 2023 corporate profits. No, U.S. stocks aren’t dirt cheap, but valuations don’t seem absurdly high.

Back in May 2020, when yields on bonds and cash investments were so small they couldn’t be seen with a microscope, I argued that—for long-term investors—there was no alternative to owning stocks. Now that yields have perked up, bonds are looking more appealing.

But I’d argue there’s still no alternative to stocks for long-term investors. The reason: inflation. For most bonds, inflation represents a permanent loss of value. By contrast, over long periods, corporations have been able to increase their profits along with inflation, and share prices have followed suit. The weeks and months ahead may be rough for stock market investors. But the long term should be just fine.

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Richard Gore
Richard Gore
13 days ago

I was wondering if you would share your target stock allocation %?

Jonathan Clements
Admin
Jonathan Clements
13 days ago
Reply to  Richard Gore

I target 80%. That leaves 20% in short-term bonds to cover five years of spending money.

Richard Gore
Richard Gore
11 days ago

As a follow-up – I was wondering if have you have been @ 80% anytime in the last 10 years?

Jonathan Clements
Admin
Jonathan Clements
11 days ago
Reply to  Richard Gore

In early 2009, I was at around 95% stocks. At the market bottom in early 2020, I was at 86%. That reflects what I felt were the unique opportunities presented by those two panics. Otherwise, I’ve typically been between 70% and 80%.

Last edited 11 days ago by Jonathan Clements
Ed Hanson
Ed Hanson
15 days ago

I remember reading a little over 2 years ago that you make money in a bear market, you just don’t realize it.

Richard Gore
Richard Gore
11 days ago
Reply to  Ed Hanson

That saying never made sense to me. The only way it seems to work is if you are market timing and you are committing new money to the market at depressed prices. Otherwise, it seems that although the way forward following a bear market is probably up you still suffered the decline. Nonetheless, if it helps investors hang in there for the rebound it might be useful.

David Powell
David Powell
15 days ago

Not yet a great bargain for the SP500 but at least finally heading nearer to a fair value range.

I’m wondering if it’s going to be “weeks and months” of declines or sliding sideways in the U.S. market, or months and years while the Fed lets its crazy big balance sheet of mortgage bonds and Treasuries run off as it also hikes short-term rates. At about $100B/month after a couple warm-up months, the Fed’s unwinding of QE seems like it could weigh on earnings for a while.

Steve Spinella
Steve Spinella
16 days ago

As a numbers guy, I find it very hard to argue that keeping money under a mattress stabilizes my returns. While slightly less compelling, arguing that keeping money in bonds to stabilize my returns from stocks seems headed in the same direction.
At the same time, I totally agree that lowering risk leads to more peace.
For these two reasons, I stay invested in income-producing opportunities that are conservative, but profitable, and limit my debt-holdings (loans to family members I view as excellent risks) to a much smaller proportion (less than 10%) of my holdings, while also eliminating almost all debt from my own life.
Still, as I read about people “waiting to invest” a higher percentage of their assets in stocks, I wonder what I might be missing. Is this the one kind of market timing that actually makes sense, or is it just another risk I would rather minimize?

John Wood
John Wood
16 days ago

I think your last paragraph captures it perfectly, Jonathan. Other than the Fed’s manipulation of interest rates, and the relative returns for large foreign investors (like Japan), I can’t fathom why U.S. institutional bond investors are accepting yields that are so far under current inflation rates. I keep waiting for the Bond Vigilantes to awaken from their deep slumber!

Rich Esto
Rich Esto
16 days ago

I agree. Whenever I’m in doubt, I just look at a 10-year or longer chart of the major indices. It shows me that even the greatest drops in value are but a blip on the radar and that the indices recovered. So a little time and patience is all that’s needed.

Kevin Knox
Kevin Knox
17 days ago

Larry Swedroe has a good post on this topic that’s being widely discussed on Bogleheads and other forums. Among other things, he shows that stocks only protect against inflation over time frames that exceed those of most investors. On the other hand, TIPS with a soupçon of select stocks and commodities does help.

https://www.advisorperspectives.com/articles/2022/04/25/which-asset-classes-protect-against-inflation

Philip Stein
Philip Stein
17 days ago

Thank you, Jonathan, for another sober analysis that helps us remain rational in an emotionally-fraught market. I would venture to say that your occasional blogs are one of the major reasons the HumbleDollar site is so useful to so many people.

You wrote that “over long periods, corporations have been able to increase their profits along with inflation, and share prices have followed suit.” I would add that dividends have also tended to increase over time and provide another reason to not abandon stocks. Those increasing dividends have helped investors counter inflation, as opposed to nominal bonds.

Paul LaVanway
Paul LaVanway
17 days ago

The world-class investor, Warren Buffett, would agree with you!

Joey
Joey
17 days ago

“But I’d argue there’s still no alternative to stocks for long-term investors.”

I agree from a growth standpoint, with the caveat that investors need to understand that the role of bonds in the portfolio isn’t for growth–bonds are for stability and overall portfolio protection during stock downturns (2022 notwithstanding, lol).

If used properly (e.g., rebalancing), bonds in a portfolio can help in at least two major ways:
1) Stops investors from panic selling when stocks decline, because an overall portfolio will not suddenly plummet 15%, 20%, or 30% in a relatively short time
2) Stops investors from necessary selling when sticks are low if they need funds to pay for college, house, medical expenses, etc.

I think of bonds as a type of like portfolio insurance: you’d prefer not to have to need them, but if you do–boy, are you ever glad that you had them!

Rick Connor
Rick Connor
18 days ago

Jonathan. Thanks for the calm amid an angry sea of stocks. I’ve been reading about finances for decades and was well aware of sequence of returns risk, and put aside cash and short term bonds to be ready. But it is still scary

Guest
Guest
18 days ago

Thanks JC. A good reminder. It always come back to the investment horizon. And it’s funny (sad really) how many investors long term investment horizon all of a sudden “shortens” when the market declines. All sorts of excuses to explain their desire to bail out when times get rough. I suppose I’ll just keep taking advantage of that twitch in human behavior.

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