On March 5 the Dow Jones Industrial Average closed at a record high — and again on March 7 and March 11. In fact, since the Dow closed at a low of 6,547 back on March 9, 2009, it has advanced more than 120% through the end of April (exclusive of dividends paid).
So, with the market hitting new highs, what does one do now? Is there still an opportunity to get into the market, or should investors avoid buying in altogether? Before you can answer that question, you have to answer these: what is your investment time horizon and how risk averse are you?
Generally, if your time horizon is less than five years for the funds you intend to invest in, then probably you should not expose yourself to the volatility of the stock market at current levels. However, if your time horizon is more than five years, then you must examine your risk tolerance as there are market-related risks (i.e. economic, financial and geopolitical) that can impact the underlying performance of the stocks in your portfolio — risks over which you have absolutely no control!
Many investors — spooked by a series of domestic and global financial crises — have been sitting on the sidelines unsure where to invest their money. Hoping to stem their losses, many have withdrawn their money from the market altogether and have parked it in cash, short-term U.S. Treasury instruments, and bonds.
Hindsight is always 20/20, so now that the economy is improving and the market is hitting all-time highs, these same investors are wondering whether or not they should get back into the market, and, if so, where and in what should they invest.
Let try to answer this question by process of elimination. With interest rates at an all-time low the Federal Reserve is, in essence, flooding the market with cheap money for the express purpose of stimulating business investment and the consumer. Until such time as the economy gains traction, business picks up and consumer spending accelerates, interest rates will remain at artificially depressed levels. So, what does this mean for fixed income investments over the near term?
Money market accounts, certificates of deposit, and U.S. Treasuries, although safe, are taxable and yield virtually nothing after tax. Next in the pecking order are fixed-income investments — bonds. However, when interest rates go up the value of bonds, especially those with longer terms to maturity, will drop in value. Therefore, the yield on these investments may be more than offset by the drop in value and, as such, investing in these investments may result in negligible after-tax rates of return.
This is known as interest rate risk. In other words, as interest rates rise, the price of bonds goes down and vice versa. By way of example, a 1 percent increase in the yield, say from 6 percent to 7 percent, on a bond that bears a coupon interest rate of 5 percent with 15 years to maturity will suffer a loss of nearly 10 percent. So, does parking your money in an instrument that suffers a 10 percent loss to generate a 7 percent yield make sense? Obviously, not!
So, assuming interest rates have nowhere to go but up, you have an investment time horizon of five or more years, and you can tolerate some market risk over the foreseeable future, then the stock market becomes the default investment!
Now the question becomes, if that is the case then how do I go about choosing equity/stock-related investments?
There are three determining metrics I look for when investing in stocks:
· A low(er) price-to-earnings (P/E) ratio relative to the overall market.
In other words, how much am I willing to pay as a multiple of earnings for a share of a company's stock? For instance if the market is trading at a multiple of 14 times earnings, I want to focus my attention on stocks that are selling at that multiple or less than that multiple — not substantially higher.
· The company produces a product or service that is a necessity of everyday living.
For instance, when you get up and shower in the morning, Procter & Gamble comes to mind. When you sit down for breakfast before work, Kellogg and General Mills comes to mind. When driving to work, Exxon Mobil comes to mind.
· The stock has to yield a dividend.
In other words, I have to be compensated for holding a company’s stock! As a shareholder of common stock in a publicly traded company, I am entitled to the net profits of that company payable to me as a dividend. Generally, I look for companies that generate a dividend yield (dividends divided by price) of 3 percent or greater.
Lastly, even though the market has recently broken records, does that necessarily mean that it is expensive? The answer: not necessarily so.
Historically, the market P/E ratio has been higher than the current level. Additionally, with cheap money in abundance, record low interest rates and a slowly improving economy, the market, although not "cheap," probably has room to go higher (barring any unforeseen economic or global interruptions).
Is the glass half empty or half full? I am cautiously optimistic, so I believe it is half full. And remember the three P's: Price Earnings, Product and Payout.
Thomas R. Kosky is a principal of the Asset Planning Group, Inc., in Coral Gables, Fla. The company specializes in investment, retirement and estate planning. In addition, for more than 20 years, Tom has taught graduate-level corporate finance in the Executive & Health Care Executive MBA Program at the University of Miami in Coral Gables. He welcomes your inquiries and comments and can be reached at (305) 666-5198 or via email at TRKosky@aol.com.