January 2, 2017
After last year’s 12% gain in the S&P 500, investors should brace themselves for a more difficult time. Not only is that number higher than the 10% average annualized stock market return over the past century, it follows several good years. The Dow sits just under 20,000, having climbed from 6,547 on March 9, 2009—a sobering fact for the many who sold at the bottom and still sit on the sidelines waiting to get back in. If that’s not a sure lesson against timing the market, I don’t know what is.
But now domestic stocks sit at higher than average valuations, as the Fed gets set to further raise rates and normalize monetary policy. An unpredictable and erratic President soon governs. Fiscal policy is headed for inflationary deficit-spending coupled with massive tax breaks.
I don’t want to imply that uncertainty is something unique here and now, however. Uncertainty is the rule of markets, not the exception. What really upsets the apple cart of the stock market is not the concerns of the day, but the concerns of a day yet unseen.
So what should an investor do, especially as bond yields remain disappointingly low (even after the stark rise in rates over the past quarter)?
Three principles should govern money management for the coming year: (1) bond duration should remain short (ideally under 5 years) and cash abundant, given that the extra 90 basis points in yield on the 10-yr Treasury Bond is not yet enough to compensate for future rises in rates; (2) investors should look outside the U.S. for better valuations elsewhere, such as the emerging markets and Japan; (3) asset allocation should continue to be determined by risk preferences and time horizon, rather than any macro speculation.
Good news for investors will come in the form of higher interest rates over the next couple of years, hopefully sooner. As rates rise to normalized levels, bond holders will once again be able to earn a real rate of return above and beyond the inflation rate. This will be sweet indeed after suffering with punishingly low yields for so long. When the 10-yr treasury yield finally rises to approach 3%, I will invest sidelined cash back into bonds and consider lengthening the duration on bond positions.
With best wishes for the coming quarter.