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Protecting against an expensive market

John Rekenthaler  |  31 Mar 2021Text size  Decrease  Increase  |  
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This column was originally published on June 21, 2016. Strangely, I would scarcely change a word if I were to write it today. That is because the market trends that prevailed in summer 2016 have continued to prevail, almost unabated. (It is for that reason that historically based fund rankings, such as the Morningstar Rating for funds, have been unusually predictive over the past five years.)

Indeed, two of the column's three suggestions have become even more attractive. Value and emerging-markets stocks are relatively cheaper than in 2016, thereby being even better positioned to defend against price bears. (That doesn't mean that they will profit if the stock market nosedives—probably not—but they should lose less than the glamorous US growth stocks that led on the way up.)

Nothing much has changed with the third option, preferred stocks. It remains a valid choice for those worried about high market valuations, particularly as the global economy is forecast to grow robustly over the next couple of years. (Preferred stocks tend to be credit-sensitive.)

Two species of bear

There are two principal ways to get clocked by the markets. One is to hold economically sensitive securities—stocks, credit-sensitive bonds—entering a recession. The other way is to own expensive investments before they are revalued and marked down. (Sometimes, as in 2008, both storms arrive.) The first case is a recession bear, and the second a price bear.

Defending against recession bears is straightforward. When economic fears drive security prices, high-quality bonds and cash always win. There's no going wrong with Treasuries. With stocks, large companies that have low debt and stable, recession-resistant revenues will withstand the bear better than the rest. Predicting when the economic sell-off will occur is tricky indeed, but knowing how to invest is not.

Guarding against price bears is more situation-dependent. What thrives in one downturn may not thrive in another. For example, small-company value stocks got pounded along with other equities in October 1987 but held up splendidly during the 2000–02 growth-stock sell-off. Similarly, high-quality bonds might perform well, as investors make "risk-off" trades and flee to safety, or they might get whacked because interest rates are believed to be rising.

Bear

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This past weekend, The Wall Street Journal's Jason Zweig forcefully argued that now is a good time to fend off the price bear. In "Everything Is More Expensive Than It Looks," Zweig points out that the only justification for today's stock-market price ratios (price/anything: earnings, book value, sales, you name it) and exceedingly low bond yields is a puny discount rate. Investors expect the return on a future risk-free security (say, Treasury bills) to be very low, which makes them willing to pay up for risky assets.

That's all fine and good ... until that discount rate changes. Then the dam bursts. As Zweig puts it, our collective investment success depends upon a "continual bull market." If the discount rate remains low (and the economy doesn't collapse), stocks and corporate bonds will likely outgain their safer competitors. Any increase in that rate, however, would put an end to seven years' worth of good fortune.

It's not for me to state when that day will arrive. But, seven years into the current cycle, it's certainly worth considering what might help a portfolio should the prevailing regime change.

Value's value

One relative haven, Zweig proffers, might be value stocks. October 1987 aside, value stocks generally hold up better than their peers during price bears. As their price multiples are already lower than other stocks', they have less room to fall. More profoundly, because (by definition) value-priced companies throw off higher current cash flows per amount invested than do other companies, they are less affected by rising discount rates. Growth stocks, to use the parlance of bond investors, have longer durations than do value stocks.

Also, value stocks are now a bargain. Although they comfortably outgained growth stocks over most previous decades, and invariably over all truly long-term horizons (say, 25-plus years), they've lagged in the trailing 10-year period. This is particularly true of larger companies, with the average US large-growth fund beating the average large-value fund by almost 2 percentage points per year through the end of May.

MORE ON THIS TOPIC: Is value investing back for good?

Growth stocks' success can be logically explained. Throughout the time period, many of the biggest growth companies (most notably Apple (AAPL)) have exceeded revenue and earnings expectations; their gains have been no fad. Nonetheless, the fact remains that growth stocks now trade at a larger premium to their value rivals than is customary; that premium will most likely contract should the market decline.

The unlikely path

Zweig's other suggestion is emerging-markets stocks, which seems a peculiar choice. Normally, one does not fend off a market sell-off by investing in among the most volatile and unpredictable of equities. However, these are not normal times for the emerging markets. Their stocks now carry substantially lower price/earnings ratios than do those of developed markets, the largest such gap in two decades.

Price bears most severely punish expectations, and the expectations of emerging-markets stocks are the lowest that I can recall. True, the 1998 Asian crisis created panic, with many worried that the Pacific emerging markets had dug themselves a hole that would take many years to escape. However, there was always the underlying optimism that once the problem was resolved, emerging markets would reclaim their destiny. That belief has withered.

Obviously, this proposal must be considered in relative terms. Emerging-markets stocks will not rise during a global sell-off. They, as always, are a "risk-on" proposition. But, given the pessimism with which their shares are currently valued, they may be something of a win/win, outperforming other equities if the bull persists, and holding up better than most should the price bear arrive.

The pundit's pun

Directly on the heels of Zweig's column came an editorial by the respected investment writer Burton Malkiel, "The Preferred Path to Higher Returns." The title foretells the story: Malkiel recommends preferred stocks for today's environment.

This tale, unlike those of value and emerging-markets stocks, does not involve underperformance. Preferred stocks have fared well in recent years. The argument does, however, rest on relative value. At 5.75 per cent after paying expenses, the yield of a preferred-stock ETF that invests primarily in investment-grade companies dwarfs the payouts of corporate bonds (or cash). True, preferred stocks are lower on the credit ladder than are bonds—but should that drawback be priced at a full 400 basis points per year?

Malkiel says not. I tend to agree. Mostly, stretching for yield is a bad investment habit. Many fixed-income disasters have occurred from investors choosing a poor investment with a high payout over a sound investment with a middling payout. At today's prices and current market conditions, though, preferred stocks would appear to be one of the exceptions to the general rule.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

is vice president of research for Morningstar.

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