With the economy improving, stocks are still the place to be. Illustration by Brock Davis By Anne Kates Smith, Executive Editor From Kiplinger's Personal Finance, July 2013 If last year’s bull market was a "stealth" rally that many investors didn’t even know existed, this year’s advance has been impossible to miss. But it’s a tale of two markets, all bullish on the outside, full of skepticism within. The market, measured by Standard & Poor’s 500-stock index, has returned 16.6% so far this year, smashing records in the process. But as market indexes scaled new heights, second-guessers wondered whether it was time to get out — before many sidelined investors had even gotten in. See Also: Morgan Stanley's Guidance: Lean Towards Stocks, Cash We think the bull market has life left in it. That's especially true for long-term investors who can weather the inevitable pullbacks and pauses. The U.S. stock market, and in particular large-company stocks, remains compelling. (For a view of the outlook for foreign markets, see Look Overseas for Cheap Stocks.) The market has reasonably sound economic underpinnings. Despite trading at all-time highs — the Dow Jones industrial average recently blew past 15,000 — stocks do not seem overpriced. And with interest rates low and virtually guaranteed by the Federal Reserve to remain so through year-end and into 2014, stocks face little competition from bonds or savings accounts. "From here to the end of the year, the market will go up enough that stocks are the right place to be versus alternatives," says Bob Doll, chief stock strategist at Nuveen Investments. "But the pace of gains will be noticeably slower." (Returns, prices and yields in this article are as of May 29.) More gains coming The market's breathtaking advance has surpassed many people's expectations including ours. In our January outlook we predicted that the S&P could return 9% this year, which it accomplished by the end of the first quarter. We now think stocks will end the year with percentage returns in the mid to high teens, which means they'll manage to hang on to what they've logged so far, with some ups and downs likely along the way, and maybe tack on more. Investors are proving themselves willing to pay more for every dollar of corporate profits, even if profit growth itself is moderating. "Now, it's not about earnings, but about the value you place on those earnings," says Jim Paulsen, chief market strategist at Wells Capital Management. In a shaky economic recovery, investors are reluctant to pay up for profits when it's unclear how fast, or if, they can grow. Coming into 2013, says Paulsen, people started to believe that economic growth looked sustainable. "Not fast, but sustainable. That's a big deal for the valuation of stocks," he says. Advertisement Stocks are trading at 15 times estimated 2013 earnings, compared with just 13 times a year ago. Is the higher price-earnings ratio justified? Consider: At market peaks in 2000 and 2007 (levels close to where the S&P 500 recently traded), stocks sold at 25 and 15 times estimated earnings, respectively. Corporate profits, however, are higher today, and companies are paying out more of those profits as dividends; inflation and corporate debt in relation to asset levels are lower. Also, interest rates on competing bond and savings investments were higher at the previous peaks. Signs of economic growth have been encouraging, but spotty. Kiplinger expects gross domestic product growth as low as 2% this year, clipped by the forced government spending cuts that took effect in the spring, and 2.9% in 2014. But consumers have remained remarkably resilient, the housing market is picking up steam, and the most recent report showed that the unemployment rate fell to 7.5% in April, the lowest level since December 2008. "Markets don't move on absolutes of good and bad," says Richard Bernstein, CEO of Richard Bernstein Advisors. "They move on better or worse. The economy might not be good in an absolute sense, but it's hard to argue that it has not improved." A heated topic of discussion these days is whether the market will collapse when the Fed backs off its low-rate, easy-money policy. The bulls argue that such a bump-up in interest rates would both confirm stronger economic growth and accelerate a rotation of investment assets from bonds into stocks, since bond prices generally fall when rates rise. Besides, says Paulsen, for stocks to prosper in the long term, the Fed must make clear its resolve to fight inflation by returning to a more normal monetary policy. Skepticism about the prospects for the current bull market, now in its fifth year, has been one of its hallmarks, but naysayers are coming around — so much so that market watchers who track investor sentiment are wary. That’s because sentiment measures are contrary indicators the more bears there are, the better the prospects for stocks and vice versa. A recent survey by AAII (the American Association of Individual Investors) found that nearly 49% of investors were bullish on stocks. That’s a big jump from less than 30% in mid-April, and above historical norms — but still below levels seen at market peaks. Advertisement Sentiment measures are contrary indicators the more bears there are, the better the prospects for stocks and vice versa. When Wall Street's recommended stock allocation is below 50%, stock returns have been positive over the next 12 months 100% of the time, says BofA, which began tracking the indicator in the 1980s. Investors who've shunned the stock market, forgoing a 167% return since the March 2009 bottom, rightly wonder whether it's too late to invest. The economic recovery recently surpassed the average length of expansions over the past 80 years, says market watcher Jim Stack, of InvesTech Research. And bull markets have lasted an average of less than four years. But, Stack says, economies and bull markets rarely die of old age alone. His conclusion: "Never second-guess a bull market." To see where to put your money now, and to spot warning signs that could mean trouble for the bull, read on. Six savvy market moves 1. Get in the game After a blistering 21.8% run since last November, the market is due for a pullback — and it's the time of year when we often get one. Still, those who've been waiting for a big decline to commit to stocks have so far been disappointed. If dips lure investors from the sidelines (or from the bond market) into stocks, then corrections could be short-lived and shallow. So don't wait. The advice from Scott Wren, a strategist at Wells Fargo Advisors, is to put one-third of any money you have earmarked for stocks in the market now. Deploy the rest at regular intervals, a technique known as dollar-cost averaging. The strategy makes it easier to stick to your plan when the market experiences one of its periodic hiccups. You'll also buy fewer shares when they're expensive and more when prices are down — which will work to your advantage during the increasing volatility that Wren predicts over the remainder of the year. If you've already reaped sizable paper gains, don't be afraid to take them, says Ron Florance, managing director of investment strategy at Wells Fargo Private Bank, which serves wealthy clients. You should rebalance your portfolio to bring it back into alignment with your desired mix of stocks, bonds, cash and perhaps other categories. Selling winning asset classes to invest in laggards is a discipline that Florance admits feels strange but is necessary to manage portfolio risk. "So many investors have a momentum mind-set, and rebalancing may seem counterintuitive," says Florance. Try rebalancing by date — the first of the year, say, or the first of the quarter — not by what goes on in the market. Advertisement 2. Stay defensive The best offense in the market this year has been to play defense. Investors are starting to believe in the bull. But just in case, they're appeasing their inner skeptic by favoring defensive stocks — those with above-average dividend yields, below-average volatility and relatively little sensitivity to the vagaries of the economy. So far this year, health care stocks have risen 23%, on average and companies that make consumer staples (the goods that stock our pantries, laundry rooms and bathroom shelves) are up 19%. Will the trend continue? Bull markets are often led by stocks that thrive when the economy is ready to hum, such as those in the technology, manufacturing and raw-materials sectors. It's not too early to keep an eye on these groups, but for now, a conservative stance still makes sense. After all, the stock market has exceeded the expectations of many pros this year. And anyone who's been in the market the past three summers knows that the span from May through October is fraught with danger. The challenging six-month period brought declines in Standard & Poor's 500-stock index of 16% in 2010, 19% in 2011 and 10% last year. Defensive stocks can provide cover during market pullbacks. Since 1990, health care and staples stocks have beaten the S&P 500 through the dicey May–October period. Nervous investors can bolster their defense with exchange-traded funds designed to dampen market swings, such as PowerShares S&P 500 Low Volatility (symbol SPLV). Such investments let you "still go to the amusement park, but ride the merry-go-round instead of the roller coaster," says S&P Capital IQ strategist Sam Stovall. Advertisement 3. Stick with dividends What's not to like about the darlings of the stock market? Historically, dividends account for some 40% of stock returns, and they're 70% less volatile than corporate earnings. From 1972 through the end of 2012, companies that initiated and increased their dividends returned 9.5% annualized, compared with 1.6% for stocks that paid nothing, says a report from J.P. Morgan Asset Management. Dividend investors earn plenty, and keep more. The dividend yield on the S&P 500 index, at 2.1%, is roughly equal to the recent rate on ten-year Treasuries. But dividends, which Uncle Sam taxes at a top 23.8% rate, have an advantage over interest income, which is taxed at a top federal rate of 39.6%. Corporate America is on the bandwagon. The number of companies initiating dividends reached an 18-year high in 2012, says J.P. Morgan. And yet dividends have room to grow. Despite cash-rich balance sheets, the share of corporate income paid out in dividends is well below historical norms. Still, dividend investors need to be choosy — and careful. "Investors are starting to do wacky things to stretch for yield," says Richard Bernstein, of Richard Bernstein Advisors. "They have this notion that investing for dividends is riskless." The stocks could stumble when interest rates finally rise. Many dividend favorites, particularly among utilities and consumer-goods companies, are becoming expensive. Better to hunt for companies that are boosting payouts, rather than the ones with the highest yields. You'll find plenty in Vanguard Dividend Growth (VDIGX), a member of the Kiplinger 25. 4. Size up these sectors Health care stocks offer investors a triple advantage, says Mary Ann Bartels, a strategist at Bank of America Merrill Lynch. Many offer attractive yields; they're defensive holdings in an uncertain market; and the case for long-term growth is the best it has been in years. Drug companies have weathered a slew of patent expirations, and their pipelines are filling with potential blockbusters. Morningstar analyst Damien Conover recommends Sanofi (SNY, $55), a Paris-based global giant that he says is well positioned in the diabetes market. James Swanson, chief strategist at MFS Investment Management, thinks technology stocks are a bargain. "It's striking that good companies in this sector are trading at lower price-earnings ratios than utilities in Ohio selling the same electricity they sold 60 years ago," he says. At the peak of the tech bubble in 2000, the sector supplied 15% of the S&P 500's earnings but accounted for more than one-third of the index's value. Today, it supplies 19% of the earnings but accounts for less than one-fifth of the value. Another change: Tech stocks are less volatile than the market. Prospects are bright. Businesses are ramping up spending on hardware, software and networking systems after years of deferral, and companies are moving massive amounts of data to the cloud. Stocks addressing those themes include Cisco Systems (CSCO, $24) and Microsoft (MSFT, $35). 5. Pick stocks with a story Investors have been frustrated in recent years as stocks have moved in lock step, regardless of the story behind each individual company. Bad news from Europe, bickering lawmakers here or a disappointing economic indicator could pull the market down en masse. But that's changing. "It's more of a stock picker's market," says Saira Malik, head of global stock research at TIAA-CREF. "You can do your homework and put together a portfolio of stocks that trade on their own fundamentals, rather than trying to figure out how macroeconomic events will move markets." Malik looks for companies that are gaining market share, are able to raise prices or are creating efficiencies that will boost profit margins regardless of where they trade. Take Bayer AG (BAYRY, $109), the German pharmaceutical giant. Despite the challenges of the European economy, Bayer, which does business all over the globe, could enjoy double-digit earnings growth, Malik predicts. Plus, the company is returning cash to shareholders via dividends. Malik also recommends Realogy (RLGY, $53), which owns Century 21, Coldwell Banker and other real estate firms. The company is a play on the U.S. housing recovery, but is also improving its finances by paying down high-cost debt. Lower interest expense could add $1 a share to earnings over the next 18 months, says Malik. Signals are green for railroads. Housing-related cargo, at 6% of rail volume, is half the historical average and should grow with the housing recovery. Meanwhile, shipping prices should rise as railroads close the gap between what they charge and truckers' higher costs. Malik favors Union Pacific (UNP, $157). It should benefit from more crude-oil shipping. 6. Tame interest-rate risk For now, the Federal Reserve Board is signaling a continuation of rock-bottom rates for the rest of the year and into 2014. But when yields rise, as they eventually will, income investors will take a hit because bond prices move in the opposite direction of interest rates. Managers at Metropolitan West Unconstrained Bond (MWCRX), a member of the Kiplinger 25, have built a portfolio to protect against rising rates. The fund yields 2.5% and carries an ultra-low average duration of 1.4 years. That means the fund would lose roughly 1.4% if rates rose one percentage point. Investors seeking higher yields can still find them in riskier issues. "Until you have to worry about the health of corporate America, low-quality debt looks good," says strategist Alec Young, of S&P Capital IQ. Now is not the time to worry, Young says, with the default rate on high-yield bonds just 2.5%, well below the 4% average. SPDR Barclays Short Term High Yield Bond ETF (SJNK, $31), which holds mostly short-term, junk-rated debt, yields 3.8%. (For other suggestions on how to pump up your income, see 45 Ideas for Getting More Yield.) Income investors who abandon the low-yielding bond market for fear of rising rates are risking another portfolio calamity. Bonds — especially high-quality bonds, such as Treasuries — are the best way to balance the risk of a bear market in stocks.