Winning Portfolio Stategy For Flat Markets

|
Includes: LDP, PFF, PFXF
by: David Cretcher

Summary

The NASDAQ 100 has hit a new high.

Market returns are flatter than realized.

Aim to beat inflation, not the market.

Last week the NASDAQ 100 was on a roll surpassing it's 2000 high. That's right, the NASDAQ has been flat for 15 years. If you had invested $10,000 in the NASDAQ in 2000, after 15 years of waiting, you would now have a about what you started with. On the other hand, if you had been conservative and invested it in a government treasury bond, then paying 6.94 percent, you would now have $20,614 - without reinvesting your interest.

The conventional wisdom that young investors should be aggressive, because in the long run you will always be ahead, is simply not true. The next time a stock salesman says you can't make money in bonds; you should take pause. Guidance like this is always circumstantial, and it the circumstances aren't right, neither is the advice

Is this simply a strange circumstance? Is it unusual to have flat markets. The truth is it is not just unusual, it is the rule.

Over-enthusiasm About Stocks

Stocks are over-sold to amateur investors and many of them overestimate the financial rewards of stock ownership. Historically the in the short-run the market makes bull-market gains, and bear-markets loses, but the broad inflation-adjusted market movement is flat.

Much of what we see as stock market growth is an illusion. It is simply inflation. Graphically, if you are earning the rate of inflation, it looks like it a pretty good investment (fig.1). Investing ten dollars in 1947 gives you 110 dollars now, ten times your initial investment.

Who wouldn't want that kind of return? Unfortunately, ten dollars in 1947 has the same buying power as 110 dollars today, so you're just even. So realize when you look at a stock market graph this is a large part of what we see as growth.

Figure 1: This is a graph of the GDP price deflator. It shows us that ten dollars in buying power in 1947 now requires 110 dollars. Adjusted for inflation, a ten dollar stock in 1947 is worth 110 dollars now. The money increases, but the wealth is constant.

Realize, the typical graph of stock prices is a combination of rising inflation (fig.1) plus the flat real growth of stocks (fig 2). To understand stock market gains, we should strip out the inflation and look underneath, at the real inflation-adjusted return. This is the truth of how our wealth is growing.

Historically, flatness is the rule - not the exception. In general, the inflation-adjusted market is characterized by decade long flat periods with short sporadic periods of growth (fig 2). Removing the inflation, we see long volatile periods when the market doesn't beat inflation and our wealth does not grow.

Sixteen years of flat performance.

We have see an impressive bull-market since 2008, but adjusted for inflation, stock prices are where they were in June of 1999.

As shown in Fig. 2, adjusted for inflation, the market was flat for 24 years from 1968 until 1992, and for 68 years from 1882 until 1950. Over the last 133 years, the inflation-adjusted market has been even for 102 years - 75 percent of the time. The market has shown inflation adjusted gains only twice in over 100 years - for a period of time between 1950 and 1978 and a second period between 1986 and 1998.

In the very long-term the market moves up, from 90 to 1970 in 144 years, an inflation-adjusted average of 2.2 percent per year, but it did it within short periods of sporadic gains in the 1950s an the 1990s.

Figure 2: The inflation-adjusted stock market is characterized by long volatile periods of flatness and short sporadic periods of gains. (source: Multpl.com)

If investors can't catch the rare secular up period, they're just treading water. The idea that we should invest a portion of our wages in stocks and just hold it is not the entire story.

Ten Percent Per Year Broken Down

Over the last 144 years, the widely-pitched ten percent stock market return is actually 8.9 percent composed historically of 4.4 percent in dividends, plus 2.2 percent in retained earnings, plus 2.3 percent in inflation. The divided composes half of the gains and has been twice as important to investors as the market gain - 2.2 percent. As noted, seventy-five percent of the time the market just pays inflation plus the dividend yield.

This is a problem for today's market. Now, the dividend yield is 2.2 percent and inflation is almost non-existent at 0.4 percent. Adding it up, 2.2 dividends, plus 2.2 percent retained earnings, plus 0.4 percent inflation totals to 4.8 percent. That's a long way from ten percent. Unless companies are retaining much higher percent of their earnings, or using them to buy-back stock, we can't expect much more than a five percent return over the long-run.

A Volatile Inflation-Adjusted Bond

Over time, the stock market behaves like a volatile inflation-adjusted bond that pays a dividend. This is one reason most amateur investors don't make long-term gains in the market. Without the rare sporadic gains from retained earnings, an investor is looking at a 2.2 gain after inflation. At that rate, it will take almost 30 years to double your money in real terms. That's a lifetime of retirement savings.

To earn this 2.2 percent, the investor must take a lot of risk. The inflation-adjusted market fluctuated from +46 percent in the best year (1936) to -37 percent in the worst (2009). Be weary of the cable news cheerleaders, stocks are riskier than they look and always have been.

Unless the investor can time the bull and bear markets, it is difficult to make sustained inflation-beating returns. It is hard to outpace inflation with a simple buy and hold strategy.

The moral of the story is, we probably need to own fewer stocks and instead find a way to beat inflation over time. We should aim for a strategy the beats inflation by five percent per year. At that rate you portfolio will double in real terms every dozen years.

More Dividend Less Volatility

If stocks are less lucrative than advertised, where should your investment dollars go? In general, investors need more income producing securities. Especially, securities that pay a large premium over the inflation rate. Investors seek to generate more dividends and less volatility in their portfolios. Find securities that will provide a steady gain over inflation during the flat periods in Fig. 1.

Because the there is a risk the Fed might raise interest rates, investors should seek securities that are less sensitive to an interest rate increase.

Currently, many medium-grade preferred stocks and exchange-traded bonds pay five percent or more at a time when inflation is almost non-existent. These investments can provide a nice inflation-beating dividend.

Also, because most of these securities are callable, they tend to trade near par value, giving investors a high-yield investment without the call-risk and premium of a high-coupon bond. The long maturities and high dividends, help to make them less sensitive to interest rate hikes.

Preferred stocks are best bought individually. In very small accounts, it might make sense to use an ETF like the iShares U.S. Preferred Stock ETF (NYSEARCA:PFF), or the Market Vectors Preferred Securities ex Financials ETF (NYSEARCA:PFXF), but the expense ratio cuts into the yield and many are weighted with more liquid but lower yielding stocks.

There are also highly discounted closed-end funds that are leveraged, for risk-tolerant investors looking for additional dividends and risk parity in their portfolios, such as the Cohen&Steers Limited Duration Preferred&Income Fund (NYSE:LDP).

Because of leverage, these closed-end funds are much more volatile and risky. Conservative investors should consider the high-grade preferreds that supply the leverage in these funds, such as the Gabelli Global Multimedia Trust preferred shares (GGT-B).

Keep in mind, preferred stocks tend to be less volatile then common stocks, but they are not without their risks. They suffered severe market price declines during the financial crisis institutional investors sold their position to generate cash for margin calls. They are also subject to call risk. Most, however, maintained their dividends and recovered more quickly then the overall market.

The high coupons give some protection to interest rate increases, but not complete immunity, so active management is required.

Take time to review your stock allocation and your reasons for owning stocks. If the potential rewards don't match your risk tolerance, consider income-producing securities that pay more than the inflation rate.

Disclosure: I/we 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.

Additional disclosure: This article is for informational and discussion purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. All investment and speculations have risk please consult your financial and tax advisers before investing.