We talk a lot about stocks here, but asset class allocation is always in the background for every investor who wants to remain open and responsive to the market’s moods.
It is always a matter of matching perceived risk to potential returns. When it looks like stocks are approaching a near-term ceiling, we stop buying stocks to concentrate on assets that can make reasonable money.
Sometimes answering that question is easy. The S&P 500 normally climbs about 8% and pays out a 3% dividend in a typical year. However, from year to year, the ride can get extremely bumpy.
If you don’t see a route to that 11% in the next 12 months, it’s worth pivoting to the sidelines to collect a passive income until the clouds recede and blue sky opens up. That’s when bonds normally become attractive.
However, this is not a normal year, so the answers aren’t easy. The S&P 500, as a whole, looks rich right now and near-term gains look grudging until the earnings trend recovers.
That’s usually an argument that favors taking a little money out of stocks and parking it in bonds. But with the Fed already flooding the Treasury market with cash, competition for bonds has never been fiercer and the yields that buyers get have never been lower.
The Fed has made sure that investors who are buying newly issued Treasury debt today will lock in barely 1% in annual interest for the next 30 years. That’s a historical fact. The coupon rate is fixed.
And it isn’t going to change with market conditions. The only way you will ever make more money here is if other investors, who are willing to settle for even lower yields, offer to take them off your hands.
That’s unlikely. The Fed can tolerate these returns, but Chairman Jerome Powell and his colleagues have signaled that they won’t keep buying to the point where rates recede below zero. This is their comfort zone.
If anything, bond prices have a lot of room to drop when the pandemic is over and the Fed takes a breather. In that scenario, you’ve locked in 1% and will take a loss when you sell.
Inflation: Mild But Real
Meanwhile, even during the deepest economic disruption in decades, the purchasing power on your principal keeps eroding. Through July, annualized inflation has remained at 1%, and “core” inflation, factoring out food and energy, continues at 1.6%.
Those of us who remember more painful inflationary cycles know that these numbers are extremely low by historical standards. We’re a long way from the 3% that prices have climbed every year over the long term.
But even a little inflation is a dangerous thing when it compounds for long periods. If consumer prices climb at their current subdued rate for the next 30 years, you’ll get your money back when those Treasury bonds mature. However, it won’t stretch as far.
And the payments you receive along the way will only barely cover that minimal inflationary drag. Should inflation return to its former trend, you’ll get the equivalent of $70 back in 2050 for every $100 those bonds are worth today.
That’s locking in a bad deal. It’s why I’m urging all investors to rotate their “low-risk” allocations to dividend stocks that have room to maintain your purchasing power. You might even make a little money in the long term.
You won’t find that opportunity in an index fund that holds the S&P 500 in the aggregate. At best, you’ll book a 1.85% yield there. 30 years from now, those dividends will stretch almost as far as they do today.
Of course, the magic of stocks is that they represent companies that generate cash. They have management teams that seek out attractive new markets and deploy their resources accordingly.
Even the dullest stock today can grow over the next 30 years. Some of my favorite companies in this space have doubled or tripled their dividend in the past decade.
There’s always a risk that they’ll falter along the way. But when you’re looking at linchpins of the global economy like General Mills Inc. (NYSE:GIS) and Pfizer Inc. (NYSE:PFE), the odds of a disaster are almost as low as a Treasury default.
For that matter, Johnson & Johnson (NYSE:JNJ) and Microsoft Corp. (NASDAQ:MSFT) have higher credit ratings than the Treasury. They’re less likely to default on their obligations, including shareholder dividends.
I’d rather be in these stocks than Treasury bonds right now. And once that side of your portfolio is in place, it’s time to reach for higher returns from the more volatile “classic” stock side of the market.
We’ve been talking yields on my Millionaire Maker radio show. (Click here for recorded episodes and local stations). And of course, if you want my best yield stocks with the best potential to beat inflation, Value Authority is the way to go.