Summary
- Low interest rates have turned the risk profile of bonds upside-down.
- Low interest rates indicate owner-ship (equities) trumps loaner-ship (fixed income).
- 20 reasonably priced Dividend Champions for increasing income.
- Time is the investor’s most precious asset.
Introduction
Creating and designing a retirement portfolio capable of meeting your income needs has always been challenging. This has become especially difficult considering the current state of both the equity and debt marketplaces today. Bonds (fixed income) offer little in the way of income due to today’s low interest rates, which also turns their classically safe risk profile upside-down. Conversely, many fear that the current “Bull Run” in equities might be long in the tooth, which has driven many equities to becoming overvalued, and therefore also more risky than normal.
At this point, I feel it is prudent to add that I am a strong advocate of adequate and proper diversification. On the other hand, I do not believe in over-diversification or what Peter Lynch is credited with calling diworse-a-fication. Additionally, I do not believe in diversifying just for the sake of being diversified. If a given asset class does not make sound economic sense, I consider it illogical to invest in it just because others say I should. In today’s marketplace, I consider the bond market a case in point.
However, allow me to elaborate. When I did utilize bonds as an investment choice, and for most of my career I did, I always implemented a laddered bond portfolio approach. What I liked best about laddering was the flexibility that a laddered bond portfolio provided. When any of my shortest duration bonds matured, I had the choice of reinvesting into the same duration of short maturities if I believed interest rates were on the low side of the cycle. Conversely, if I felt interest rates were on the high side of the cycle I could invest my matured bonds into longer maturities to lock-in the higher yields. And of course, I could continue holding my other bonds to maturity and continue this process as each rung on the ladder became available.
Unfortunately, given today’s extremely low level of interest rates, the only maturities I would consider for even a second, are the shortest. But unfortunately, there is virtually no yield available on short-term high-quality bonds. Therefore, since the risk of price volatility in the event that future interest rates rise is so high with longer-term, and even intermediate-term bonds, I do not currently consider either of them a viable option today. Yes, bond prices do fluctuate, and with today’s interest rates so abysmally low bond prices could potentially fall as much or more than stocks ever have.
Furthermore, I was fortunately taught at a tender age that there are really only two asset classes. They are equity or debt. My early teachers referred to the two broad asset classes as “loaner-ship or owner-ship.” Therefore, you either had the option of loaning your money at interest, or becoming an owner that participates in the profit or loss of your equity of choice. In this context, there are many sub asset classes within these two broader classes. With loaner-ship (fixed income) there are bonds, CDs, fixed annuities, notes of various kinds, money market instruments, etc. With owner-ship (equity) there are stocks (private or public), real estate (to include REITs), commodities, gemstones of all kinds, precious metals of all kinds, livestock, collectibles and anything else that you can own.
Moreover, although virtually all fixed income instruments (loaner-ship) pay interest or generate income in some fashion, the same cannot be said about all equity options (owner-ship). For those desirous of, or in need of current income, the choice is pretty much limited to common stocks or income producing real estate. Consequently, at least for income investors, the choices are not as extensive as they are for investors most interested in total return or maximum gain.
The State of the S&P 500 (the Stock Market) Today
Since the beginning of 2009 the stock market, as measured by the S&P 500, has generated a strong and long bull market run, as evidenced by the following earnings and price correlated F.A.S.T. Graphs™. The orange line on the graph represents a P/E ratio of 15 representing fair value. Moreover, as the stock market recovered from the Great Recession the S&P 500 generated operating earnings growth of 14.6% which is more than double its long-term average. Clearly, monthly closing stock prices (the black line on the graph) have closely tracked and correlated with earnings since the beginning of 2009.
Consequently, there are two important considerations that I asked the reader to focus on. First of all, the S&P 500’s stock price is clearly above the orange fair value line with a blended P/E ratio of 17.3. Therefore, it is only logical to conclude that the S&P 500 is now moderately above fair value, but not excessively so. In my view, this vividly reveals that stocks in the general sense although moderately overvalued, are nowhere near bubble territory. Yes, it is true that the S&P 500 currently sits at an all-time high, but it is also true that earnings are simultaneously at an all-time high. Consequently, I believe this illustrates that the Bull Run since the beginning of 2009 is mostly justified based on earnings and stock price rising together.
Furthermore, my second point for consideration is also crystal clear. Common stocks, as represented by the S&P 500 are certainly no longer the bargain they were in early 2009. However, and I consider this vitally important, it does not logically follow that all stocks are now overvalued. This is an index comprised of 501 common stocks, and within the group investors willing to look hard enough will discover that some are in fact overvalued even dangerously, some are moderately valued, some are fairly valued, and believe it or not, some are undervalued today. Nevertheless, the evidence supports the notion that finding good value at today’s market levels might be difficult.
