Stock Watch

Why Not to Quit Stocks Altogether

Millions of investors are pulling their money out of this market, but that doesn't mean you should follow the crowd. Stocks are still right for many portfolios.

By Jeffrey R. Kosnett, Senior Editor, Kiplinger's Personal Finance

August 25, 2010

When an otherwise dull report on mutual fund flows becomes the lead story in Sunday’s New York Times, it behooves investors to pay attention. Citing data from the Investment Company Institute, the mutual fund industry’s trade group, the Times’ August 21 article reported that investors withdrew a “staggering” $33 billion from domestic stock funds in the first seven months of 2010, and it raised the question of whether the numbers suggested a long-term shift in investor psychology.

That your friends, neighbors and countrymen have grown wary -- if not sick -- of stocks shouldn’t come as a surprise. In the wake of ten years of negative returns (the result of two devastating bear markets), a surge in volatility that culminated in the May 6 “flash crash,” and the remarkably strong performance of Treasury bonds, it’s no wonder that millions of investors have been pulling money out of the lagging category of assets and moving it into something that has done so much better.

But that doesn’t mean that the turn-tail crowd is doing the right thing. Yes, the stock market is more prone than ever to terrifying accidents. But there’s no way to build anything resembling a diversified investment plan sans stocks. For more on why you shouldn’t abandon stocks, read on.

For starters, the supposedly safe alternatives aren’t especially appealing. The national average interest rate on a five-year CD is 1.8%. A few banks advertise 2.5%. Such a deal! If there’s any inflation at all and your money is in a taxable account, you make between nothing and next-to-nothing. Even in a tax-deferred account, you may even come out behind.

With interest rates falling steadily since April, bond funds have delivered handsome total returns (bond prices and yields move in opposite directions). Consider Vanguard Long-Term Treasury Fund (symbol VUSTX), which, as the name indicates, owns Treasury bonds with long maturities. Year-to-date through August 24, the fund returned a remarkable 20.2%.

But as yields fall, opportunities for additional gains diminish and risks rise. The ten-year Treasury note, which yielded 4% in April, yielded a bit more than 2.5% at the close of trading on August 24. The Vanguard fund’s duration, a measure of interest-rate risk, stands at 12.8 years. That means if long-term interest rates rise one percentage point, which is not out of the question by this time next year, the fund’s share price will likely fall about 12.8%. No matter how bad you think the economy is, it isn’t so awful that the government and the financial markets can keep the cost of credit near zero forever.

Getting back to stocks, corporate America is doing quite well, thank you. According to Thomson One, 75% of the companies in Standard & Poor’s 500-stock index beat analysts’ estimates in the second quarter. All told, S&P 500 earnings were up 38% from the same period in 2009.

Clearly, companies can’t continue to produce this kind of growth in a sluggish economy. But judging from the way investors have been pummeling stocks lately, they seem to think that a double-dip recession is in the cards and that, consequently, the bottom is about to fall out of earnings (between the market’s April 23 peak and the August 24 close, the S&P 500 dropped 13%). Kiplinger’s disagrees. We expect growth in gross domestic product of 2.8% this year and 3.4% next year -- not exactly signs of a roaring economy but not terrible, either. If the economy does continue to grow moderately, stocks look reasonably priced, at worst -- and they may prove to be downright cheap. At the August 24 close, the S&P 500 traded at just a shade below 12 times estimated earnings for the next four quarters.

Of course, it is unnerving to see stock indexes fall 2% or more in one day or 5% in a week when traders get spooked by a small rise in unemployment claims or by a housing-sales figure that is slightly less than expected. We would prefer investors to focus on real progress at places like 3M (MMM), which has an amazing array of new products, or Caterpillar (CAT) and Deere (DE), which remained profitable through the Great Recession and are seeing big increases in sales in emerging nations.

This is a great time to be looking at companies that pay large, secure dividends. You don’t have to look far to find stocks that yield more than Treasury bonds do or even more than a company’s own bonds. Moreover, a company can boost its dividend every year, while a bond or a CD generally pays you the same amount year after year (that’s why they’re called fixed-income investments). Plenty of good companies whose share prices have been stagnant for years regularly increase their payouts by 10% or more annually. These include Caterpillar, IBM (IBM), Illinois Tool Works (ITW), Johnson & Johnson (JNJ), Pepsico (PEP) and Wal-Mart Stores (WMT).

Until now, we’ve been focusing on the U.S. economy. Let’s not forget that the engine of economic growth today is the world’s emerging nations, such as China and India. It’s almost quaint to talk about China as a developing country. It has just overtaken Japan as the world’s second-largest economy. According to Bank of America Merrill Lynch, 20% of the S&P 500’s profits came from abroad 15 years ago. Today, the figure is 40%, including 15% from emerging economies.

What does all this mean for you as an investor? If you have enough money to last through retirement and old age, sure, go ahead and cut back on risk by trimming your allocation to stocks. But do not eliminate your stock positions entirely. Most investors -- especially those under age 55 -- should keep as much in stocks as their tolerance for risk (that is, short-term losses) permits.

The Kiplinger 25, the list of our favorite no-load mutual funds, is a great place to start. Funds such as Fairholme (FAIRX), Fidelity Low-Priced Stock (FLPSX), Harbor International (HIINX), T. Rowe Price Equity Income (PRFDX) and T. Rowe Price MidCap Growth (RPMGX) have delivered market-beating returns over the past ten years, and for the most part their shareholders have shown discernment by sticking with them. Of course, these funds will almost certainly lose value in a severe market downturn. If you’re looking for bear-market protection, consider FPA Crescent (FPACX), whose manager often bets against the market with some of his fund’s assets, or Arbitrage Fund (ARBFX), which invests in takeover targets and exhibits almost no correlation to the overall market.

Getting back to that New York Times article, it evokes another prominently displayed article about the stock market from more than 30 years ago. The cover story on the August 13, 1979, issue of BusinessWeek magazine was called “The Death of Equities.” While the article was not a perfect contrarian indicator -- it took until 1982 before the great, 18-year-long bull market began -- the piece and its over-the-top title did no favors to those who took it seriously enough to abandon stocks forever.

• Got a question? E-mail me directly at investing@kiplinger.com. Want to be heard? Leave a reader comment below.

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