The U.S. Federal Reserve's long-term policy of "zero interest rates" has prompted some investment advisers to rethink what allocations of bonds and equities high-net-worth investors who rely on income should hold.
With the dividend yield of the Standard & Poor's 500-stock index exceeding the U.S. Treasury 10-year note, a phenomenon not seen for roughly six decades, some investors are swapping into equities as an income alternative to bonds. That’s because the average dividend yield on the S&P 500 is 2.5 percent, compared with the yield on 10-year U.S. Treasury bonds of 1.45 percent.
In a sign that equity valuations are more competitive versus fixed income, the spread between dividend yields and Treasury yields is close to its narrowest since the late 1950s, according to a late June report by Michael Hartnett, chief global equity strategist at Bank of America Merrill Lynch.
'Disgusting' Yield Drop
The adage for bonds used to be that your fixed-income portfolio allocation should mirror your age -- a 30-year-old should have a 30 percent bond allocation, while a 70-year-old should hold about 70 percent in fixed income. That no longer makes sense, particularly for those who need income, said Marc Chaikin, chief executive officer of Chaikin Stock Research.
“With bonds yielding virtually nothing,” investors need to become “more comfortable … with equity exposure,” Chaikin said. “If you’re younger, you can take an even more aggressive approach to equities.”
Value investor Jeremy Grantham of Boston-based Grantham, Mayo, Van Otterloo & Co. is hardly pounding the table for equities, and recently called them "a little expensive" and "boring." His strongest words, however, are for fixed income, which he said he now hates, calling the drop in bond yields "disgusting."
Grantham thinks stocks are overpriced because U.S. corporate earnings are "abnormally high.” Profit margins are trending up as government debt increases -- a dynamic he said is "an artificial prop to the market," which creates an overly bullish bias because being bearish is "bad for business." He said corporate profits may be illusory, as their borrowing rates remain artificially low because of the Fed’s zero interest rate policy and an artificial boost to consumer demand from the flooding of the U.S. financial system with stimulus money.
In the long run, Grantham is bullish on stocks. Two-thirds of all corporate value in stocks lies out beyond 20 years, he said, meaning that since markets often trade as if all value lies within the next five years or even months, a company’s future worth can be undervalued. In his first quarter letter to clients, Grantham noted that since asset class selection packs "a deadly punch, the great investment opportunities are much more likely to be at the asset class level than at the stock or industry level."
AllianceBernstein's Seth Masters also thinks stocks will win out in the long run. He projects the odds of global and U.S. stocks beating bonds during the next 10 years at 88 percent today. Usually, stocks have a 75 percent chance of beating bonds over 10 years, he noted in a recent research paper for clients.
Bonds look appealing, "but if you're thinking about shortfall risk, a portfolio with 60 percent in stocks looks more attractive," Masters wrote. AllianceBernstein estimates a 65-year-old retired couple willing to withdraw just 3 percent of their portfolio has a 12 percent chance of running out of money if they keep 60 percent in stocks. That may not sound great, but it is materially better than the 24 percent chance of running out of money if they invest in a portfolio with 20 percent in stocks.
Lower Equity Returns
Shifting to equities for higher returns is not without its challenges. Some market technicians predict lower returns on stocks in the years ahead.
The stock market’s price-to-earnings ratio declined in the nine years to 2011, from 26 to around 20, using a normalized valuation popularized by Yale University’s Robert Shiller, whose formula attempts to reduce distortions to PE ratios caused by the earnings cycle by normalizing earnings over a ten-year period. The resulting ratio is often called the cyclically adjusted PE and is higher than the more commonly used PE number.
At a PE of 20, today’s stock market valuation remains relatively high historically, suggesting lower future returns, according to a study published on June 30 by market technicians John Mauldin and Ed Easterling.
Tim Lesko, a principal and portfolio manager at Granite Investment Advisors, based in Concord, New Hampshire, is rebalancing clients to much higher allocations of equities -- as high as 70 percent where suitable. “The market is schizophrenic. People gripped by fear are rushing into bonds, and at the same time they are overpaying for the Facebook IPO," he said. "For our clients with balanced accounts we are at the higher end of the equity allocation, because there’s more yield.”
Rather than try to time the market, Lesko advises investors to pick equities returning about 3 percent annually. That's higher than the current inflation rate, which fell 0.3 percent in May to 1.7 percent. He's moving his high-net-worth clients’ portfolios more heavily into blue chip dividend-yielding equities such as Microsoft Corp. (2.7 percent yield), Johnson & Johnson, (3.6 percent yield), Lockheed Martin Corp. (4.6 percent yield) and Abbott Laboratories (3.1 percent yield).
A caveat: Returns from dividends could be diminished by possible tax changes. Dividends have come under scrutiny as part of a White House initiative to raise taxes on investment income for married couples earning more than $250,000 and for individuals earning more than $200,000. If Congress doesn't act, the top tax rate for ordinary income will increase to 39.6 percent from 35 percent in 2013. The top tax rate on capital gains will increase to 23.8 percent from 15 percent. Dividends would be taxed as ordinary income.
(Erin Arvedlund is a freelance writer based in Philadelphia.)
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