Investing is a risky activity. You have to measure your own risk tolerance and execute swiftly to time the right entries and exits.
Owning bonds can be a smart decision for risk adverse investors, but with inflation continuing to climb, inflation adjusted returns when it comes to ten-year and thirty-year treasuries become increasingly less attractive.
Over time it has been proven that stocks are your best inflation hedge. Some believe that the Federal Reserve taper will put an end to our modest economic recovery as the amount of asset purchases will be largely limited going forward, thus limiting the artificial currency creation.
I think taper or no taper stocks are still where you want to be.
How high is high?
Between 1912 and 2012 the stock market (S&P 500) generated a compound annualized return of 9.72%. That's a lot of return over the course of 100-years. So assuming the market (NYSEARCA:SPY) is able to repeat that same kind of annualized performance over the next 100-years, what would the S&P 500 be trading at? Using the S&P500 close at $1,805 and assuming a 9.72% CAGR, the S&P 500 should be trading at $19,277,783.54 by 2113. Yes that's 100-years into the future, but it's still a pretty significant sum of money to think about.
This sounds either like an absolutely breathtaking prediction or a pipe dream. But, let's think of this in terms of risk. Owning the stock market over the long-term gives investors an asymmetrical risk to reward. You're not going to be up on every day you own stocks, and yeah you might experience long periods of portfolio draw down. But over the long haul, your risk to reward is pretty apparent when it comes to owning a basket of diversified stocks.
Sure, we could point out that there's always the possibility of a massive economic meltdown, black swan, recession, market crash, computer crash, and etc. But let me ask you something, when was the last time you saw the markets fall and never ever come back? Now if indeed there was a day where stock prices were to never recover, rather than investing into deflation hedges, perhaps loading up on guns, gold, and food would be the way to go.
Now in the event of an economic recession, it would probably be a better idea to own AAA rated notes that would appreciate in value due to the risk-off trade that tends to be pervasive in times of volatility. Another option for the super sophisticated type would be to pick your way through lucrative junk bonds trading pennies on the dollar. But if you want to add another notch of sophistication, try buying the MBS portfolios of defunct investment banks. Those strategies are appropriate for when asset values are deflating, but in an inflationary environment one should do the complete opposite.
Okay, okay hold on for a second… what does anything I have to say, have anything to do with the stock market? If it makes sense to own bonds during periods of market volatility just the opposite would hold true in instances when there is low volatility. Of course, a pretty solid measure of volatility would be the volatility index (NYSEARCA:VXX). Now I know I'm using a triple leveraged ETN, and yes I know that the value of these ETNs decay over time, sort of like a derivative contract. But it doesn't negate the fact that it has significantly declined in value over the years.
So I guess a surefire way to lose money would be to bet on volatility. To get a point of reference, after multiple reverse splits, the volatility index fell from $7,500 per share to a whopping $44.76 per share between 2009 and 2013. The fact is…. Being a long-term bear on the markets has never worked, and will never work, unless if you're banking on some sort of extinction event of the human race. But if that's the case you might as well build a bunker in your basement rather than invest into deflation hedges like the volatility index.
Own stocks or bonds?
The classical, I want to balance my risk and earn return, what should I do? Well, here's the fact, there's a bit of timing to this game of market rotation. Go into stocks too fast and you look like a gambler. Go in too late and you look like a total sucker. No one wants to look like the idiot buying the tops and selling the bottoms. But at the same time no one wants to miss out either. The pervasive notion of no one went broke by taking profits is fairly well-established on Wall Street. Therefore, when is the buy, and when is the sell when you're playing macro? I think it is appropriate to own stocks in 2014. You might see a short spike in volatility between bonds and stocks. Even so, it would make more sense to own stocks rather than bonds through the Federal Reserve taper based on historical indicators.
Currently bond outflows continued at a pretty rapid pace, well to be more specific they have surpassed an all-time record. At least in 2013, investors have pulled $70.7 billion from U.S. bond mutual funds. That's bigger than the $62.5 billion outflow from bonds back in 1994 when the Federal Reserve increased interest rates. In today's times, I would probably hate to be a bond fund manager. Because bond funds depreciate without the guarantee of having the principle returned at bond maturity. Owning the bond notes themselves reduce the downside risk by returning investors the actual investment principle, whereas bond funds are treated more like a security. If you own a bond mutual fund or ETF you might as well own a stock ETF. After all, bond funds are treated more like a trading instrument rather than an actual investment.
Own stocks through the taper
Now if you notice, over the past year, stock prices and bond prices fell in near tandem. This was because, with the exception of the August period where the government shut itself down, investors were adjusting to the possibility of no more Quantitative Easing. So as of the moment, markets are being thrown into a bit of a funk. I say funk, because we have to take on this awkward mentality of good economic data equals early end to taper, which negates stock prices. On the other hand, good economic data may imply the stock market may be able to support itself without the help of good ol' uncle Sam, because Good ol' American capitalism might be on track again.
Will the economy get close to the Federal Reserve's forecast of 3% GDP growth, 2% CPI inflation, and 6.5% - 5% unemployment? I think it eventually will. The trend is your friend, and when you see consistent gains in economic indicators, there's no denying the eventual transition to a "more normal" economic environment. Of course, in a more normal economic environment interest rates on risk free assets would be closer to 5%. Therefore, I wouldn't want to own 10-years treasuries now, but I would love to own a risk-free asset when the interest generated reached above my 5% threshold.
Over the past five years we saw all three key economic indicators continue to improve. I say key, because these are the indicators that the Federal Reserve bases the vast majority of its key policy decisions on. We want jobs, we want aggregate consumption and production to go up (GDP), and we want to see inflation, which is indicative of more lending.
The two exact charts I have included are pretty much the same. One represents the percentage change in the values. The other represents the actual values. The unemployment rate reached a peak of around 10% in 2010, and is currently 7% based on November 2013 unemployment figures. Let's look at CPI inflation, it's at 233.81, and has increased by 10.6% over the past five years. Not bad, but it could certainly improve. Finally, the GDP is $16.8 trillion and has grown by 16.11% for the past five years.
The economy is pretty much on solid ground when compared to 2007. It's about time the Federal Reserve starts to take its foot off the gas pedal. 2014 will be the year when the taper ends, which makes 2014 an exciting year to be an investor or a trader.
Some believe that economic growth has depended heavily on the Federal Reserve. But, I take on the stance that the economy will be able to grow with or without Federal Reserve intervention from this point forward. Uncertainty in the economic environment is more sentimental. It's all about the perception of events going around us, rather than assessing what's actually happening to the economy.
Price tells us a lot. If the Federal Reserve taper was a negative headwind for stock prices, the price of stocks would have declined in relation to bonds over 2013. After all, bonds do better in periods of volatility, and depreciate in periods of stability. With prices reflecting what investors anticipate for the next two years, the stock market is pricing in an immaterial impact from the Fed taper. If anything, the poor guys in the bond pits may lose money, especially if they're long bonds along the right hand side of the yield curve.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.