The legendary Burton Malkiel answers your questions
The stock market’s dizzying heights and occasional swoons have many investors wondering whether it’s too dangerous now to stick with stocks. Some analysts say stocks are drastically overpriced, while others say they still are the most attractive investment. We decided to interview legendary investment strategist Burton Malkiel, PhD, for his views on today’s market—and what investors should do—and we asked you, our readers, to tell us what questions you would pose to Professor Malkiel.
Your questions and his responses…
• Are stocks very overvalued?
The Standard & Poor’s 500 stock index has set all-time record highs more than 30 times in 2014. There’s no question that the market is pricey—but not excessively so. For example, in mid-October, stocks in the index were trading at an average price-to-earnings ratio (P/E) of about 18 even after a sharp pullback. That’s up from a P/E of 13.5 in late 2011, and it’s about 17% higher than the long-term historical average of 15.35. But it is far below the extreme valuations of, say, the late 1990s, when the P/E topped 30.
• Is it smart for me to add new money to stocks after a big drop in the market? Or should I take my profits and avoid the market for a while?
Thinking you can time when to get in and out in an overvalued market like this can be particularly stressful. You might buy stocks after a pullback only to watch the market continue to fall. Or you might sit on the sidelines, as many investors have done for years, only to watch the market keep rising. The fact is, no one can consistently time the market. And even though valuations are stretched now, stocks still can deliver reasonable performance over the next one to three years—and there are few other places to get a reasonable return.
• Can I still expect stocks to produce good returns for the long term?
This is what should concern investors the most. The US and the rest of the developed world are likely to experience anemic economic growth for a long time. We’ll be lucky to reach and maintain 3% annual growth in gross domestic product (GDP). When I factor that into various prediction models for the US stock market, the news is not great. I would expect average annual S&P 500 returns in the mid single digits—not the low double digits that many people are used to—for the next decade or more.
• Are there better opportunities than investing in the S&P 500?
Yes, but they aren’t in the US. Even conservative investors and retirees need to consider adding some emerging-market stocks to their portfolios. These stocks, which have become substantially undervalued during the long US bull market, can provide annual returns averaging above 10% over the next decade or longer. Emerging markets now make up half the world’s economic activity. They are volatile, of course, but as part of a diversified portfolio, the risk will be manageable.
You can get low-cost exposure to emerging markets through exchange-traded funds such as the iShares MSCI Emerging Markets ETF (EEM) and the Vanguard FTSE Emerging Markets ETF (VWO). More aggressive investors might consider some excellent closed-end funds, which are selling for much less than the value of their underlying holdings. These include Aberdeen Latin America Equity (LAQ)…Morgan Stanley Emerging Markets (MSF)…and Templeton Dragon (TDF).
• Do I need to prepare my portfolio for higher inflation?
Inflation has been very low in recent years, and I don’t expect it to break out anytime soon. However, now is a good time to start building exposure to real estate investment trusts (REITs), which invest in commercial real estate such as apartment buildings and shopping malls. REITs can provide dividend income and some degree of protection against inflation as rents tend to increase when prices do. And they are relatively attractive now, having lagged the stock market over the past three years. Consider ETFs such as iShares US Real Estate ETF (IYR) and the Vanguard REIT ETF (VNQ).
• When will interest rates rise?
A combination of tepid economic growth in developed nations and a lack of significant inflation means that many central banks around the world are likely to keep interest rates lower than historical averages for many years. Just because the US Federal Reserve has indicated that it will start hiking short-term interest rates in 2015 does not mean that yields on low-risk investments, such as savings accounts, CDs and US Treasuries, will rise enough for you to live on the income they produce in the foreseeable future. In the past, I’ve recommended that investors could meet their fixed-income needs by investing their long-term bond money in a total bond market index fund. But these types of funds, which hold US government bonds and high-quality corporate bonds, recently provided meager yields in the 2% range. And if I am wrong about interest rates and they do suddenly spike, bond prices will plummet and these funds could easily lose 5% to 15% of their value.
• How should I adjust my portfolio for the likelihood that rates will rise sharply?
Consider dividing your long-term bond money among three asset classes. These three entail varying levels of risk, but they can provide higher yields, better total returns and less pain if US interest rates rise…
Municipal bonds. These tax-exempt bonds, normally attractive only for investors who are in high tax brackets, today represent unusually good value versus US Treasuries even for people not in high tax brackets. The bankruptcy of Detroit and debt problems of Puerto Rico have chilled the US muni bond market. The result is that high-quality munis with very little default risk often sell with yields equal to or higher than those of comparable Treasury securities. The iShares National AMT-Free Muni Bond ETF (MUB) recently had the same yield as many taxable intermediate-term US Treasury funds.
High-quality dividend stocks. You will be better served owning blue-chip, dividend-paying US stocks now than holding bonds in the same companies. For example, AT&T’s stock recently yielded 5.2%, which is higher than the yield on that company’s 10-year bonds. And if inflation accelerates, rising prices on goods and services will help boost the company’s earnings, making the stock’s outlook and risk level compared with bonds even more attractive.
Emerging-market bonds. These investments can work for the aggressive end of your bond portfolio. Many developing nations actually are in much better fiscal shape than the US, with less debt and balanced budgets. But because their economies are less established and less trusted by investors, especially in times of global crisis, they must offer much higher yields on their government bonds in order to attract investors.
A broadly diversified emerging-market bond fund such as Vanguard Emerging Markets Government Bond ETF (VWOB) is an easy way to do this—it was recently yielding 4.6%.
Best Portfolio for You
Here are my portfolio allocations for investors of various ages who seek a balance of good performance and stability…
20s to early 30s: 75% stocks (one-half in the US, one-quarter in other developed nations, one-quarter in emerging markets)…20% income-oriented (one-third each of muni bonds, emerging-market bonds and dividend stocks)…5% cash.
Late 30s to 50: 65% stocks (one-half in the US, one-quarter in other developed nations, one-quarter in emerging markets)…20% income-oriented (one-third each of muni bonds, emerging-market bonds and dividend stocks)…10% REITs…5% cash.
50s to late 60s: 55% stocks (one-half of that in the US, one-quarter in other developed nations, one-quarter in emerging markets)…27.5% bonds (one-third each of muni bonds, emerging-market bonds and dividend stocks)…12.5% REITs…5% cash.
Late 60s and older: 40% stocks (one-half of that in the US, one-quarter in other developed nations, one-quarter in emerging markets)…35% income-oriented (one-third each of muni bonds, emerging-market bonds and dividend stocks)…15% REITs…10% cash.
