Err On The Side Of Caution In 2014

Includes: SPY, VTI
by: John Gerard Lewis

I was recently asked to respond to a couple of questions as 2014 unfolds. Here's how I answered:

What is the best way for people to play an up market after the huge gains of 2013 - what rebalancing of a portfolio needs to be done?

Several questions loom over the stock market as 2014 is under way. Especially after a market gain of about 30% in one year, any investor should remember that stocks, like trees, don't grow to the sky. Even very disciplined investors can be tempted to imprudently go "all in" if they ultimately can't resist the seemingly endless party.

The stock market will be affected by two major influences in 2014. The first is the anticipated tapering of the Fed's bond-buying program that has propped up the market for several years. Will turning off this tap reduce liquidity so much that the market is adversely affected?

The other major influence will be the economy itself. The Fed has begun tapering because it thinks the economy is improving. But is it, or was the disastrous December jobs report - the weakest monthly report in three years - an indication that the economy is, in fact, not improving?

These unresolved questions mean an investor should not assume that the party of 2013 - which, because few predicted it, was actually a "surprise party" - has not ended. It may well have. Therefore, investors should default a standard precept: allocate a percentage of 100 minus one's age to stocks. Hence, if you are 40 years old, invest 60 percent in quality, non-speculative stocks, and 40 percent in fixed-income securities, such as investment-grade bonds or bank certificates of deposit. This is no time to be exotic. Just invest in a tried-and-true manner.

For diversification and low expenses, my recommendation is to use broad-based index funds like the Vanguard Total Stock Market ETF (NYSEARCA:VTI) or the SPDR S&P 500 Index ETF (NYSEARCA:SPY).

How should people invest if interest rates rise?

We can reasonably assume that, yes, rates will rise, but the Fed has been indicating that it won't raise short-term rates until the 2015-2016 period. But with so much uncertainty about the economy and the Fed's bond-buying program, no one really knows when rates will begin rising or how rapidly they will do so.

The stock market can absorb the effect of a slow, modest increase in rates over the next several years, as long as they don't reach the stratospheric levels of three decades ago. As there is no current indication that rates will quickly rise in the near term, investing in the "100 minus your age" manner for stocks is reasonable.

The prospect of rising rates has a more direct influence on the fixed-income portion of an investor's portfolio. Bond prices closely correlate - inversely - with the direction of interest rates. And the longer the maturity of a bond or bond fund, the greater will be the effect of rising rates on its price. In other words, longer-term bonds will drop in price more than short-term bonds will fall.

Therefore, because we don't know when rates will begin to take off or how rapidly, investors should stick to short-term fixed-income investments, just to be safe. After all, the purpose of your fixed-income allocation is to mitigate the risk of your stock allocation, so why would you take "interest-rate risk" when today that risk is so high?

My recommendation for prudent fixed-income investing at this time would be, believe it or not, bank CDs. But I'm not recommending local-bank CDs, where the national average is about 0.23%. I'm suggesting CDs at certain online banks, such as GE Capital Retail Bank or Ally Bank, where you can get an FDIC-insured return of about 1%. Unlike short-term bond funds, you're guaranteed the return of your money and you know when you're going get it.

Disclosure: I am long VTI. 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.