Why You May Not Want To Go Away

Includes: DIA, SPY
by: AAII

Take the money and run or keep your allocation to stocks?

I'm sure this is a question many of you have. The market has had a good run so far this year, with the S&P 500 gaining 17.3% on a total-return basis through Wednesday's close, despite a long list of worries. Then there is the old adage of "sell in May and go away." But, Mr. Market remains in a chipper mood as is evident by the new record closes continually being set by the Dow Jones industrial average and the S&P 500.

So, should you stay or should you go? The answer is yes.

If the above response seems to have all the clarity of a response one would expect from a politician, allow me to elaborate. The current environment does not offer any good alternatives from an allocation standpoint. Cash is earning next to nothing in absolute terms and costs you wealth on an inflation-adjusted basis. Yields on the benchmark U.S. Treasury closed on Wednesday at 1.94%. Even gold is no longer glittering from an investment standpoint.

Relative to bonds, stocks remain cheap. The earnings yield on the S&P 500 is 5.8% as of Wednesday's close, a significant premium to the current yield on bonds. One could argue that stocks are no longer cheap with a trailing price-earnings ratio of 17.1, versus the average P/E of 16.6 since 1960, and a current cyclically adjusted price earnings, or "CAPE," ratio in excess of 23, but bonds are expensive too. On a valuation basis, by switching from stocks to bonds, you would simply be exchanging one not-so-cheap asset for an expensive asset. Cash not only loses out to inflation, but also incurs opportunity costs.

One of those opportunity costs is the chance that stocks will be priced higher in six months than they are now. Though the period of May through October is referred to as the "worst six months," the S&P 500 still boasts an average gain of 1.2% since 1945, according to Sam Stovall at S&P Capital IQ. It is also helpful to consider what your potential loss might actually be. To throw out some numbers for the sake of discussion, let's assume a summer correction hits and stocks pull back 10%. If the current momentum lifts the market another four percentage points between now and its late spring/summer peak, the actual decline from today will be a little more than 6%. Though nobody likes to see their portfolio decline in value, a 6% pullback is well within the range of normal fluctuations and should not be any cause to sell or worry. Keep in mind that this is just an example. When I asked my Magic 8 Ball if the market's returns will be better or worse than what I just typed, its response was "As I see it, yes."

It's not just my Magic 8 Ball that is giving a lack of clarity. Jack Schannep of the TheDowTheory.com Newsletter sent out an alert last week saying the Dow Jones transportation average's break to new record highs warranted an "in the clear" signal. He further added, "As an 'old bold pilot' the implication of rising above the clouds and being 'in the clear' is favorable, but not necessarily a permanent situation-there are usually other clouds, and some may rise into your flight path."

Confusing? Yes. Uncertain? Yes. But, if correctly forecasting where stocks are headed was easy, the long-term returns on stocks would not be 9.98%; rather they would be much lower. Over time, stock investors get compensated for incurring risk.

If you are concerned about how stocks will perform over the next six months, you could rely more on dividend-paying stocks, whose stream of income helps to cushion the blow of falling stock prices. Just pay close attention to valuation if you are seeking stocks in traditionally less economically sensitive sectors. Yields on healthcare and consumer staple stocks are down far more on a year-over-year basis than the yields on energy and technology stocks are, as we noted in the May AAII Dividend Investing newsletter. For stock hunters, these differences mean you may find more attractive valuations by looking at technology and energy stocks.

Keep in mind that this discussion is specific to the tactical question of whether you should allocate out of stocks because the best six months period is now over. Maintaining long-term allocations to bonds and cash still makes sense from an overall portfolio allocation standpoint.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.