c.2013 New York Times News Service
c.2013 New York Times News Service
It’s a very risky environment for the markets right now. It’s also a very good time to be an investor.
These two propositions may seem contradictory, but they’re not — at least in the view of David P. Kelly, chief global strategist at JP Morgan Funds.
“There are many problems in the economy and in the markets, certainly,” Kelly said in an interview. Short-term losses could easily be on the way, and they could be painful. “But the answer for a long-term investor isn’t to avoid risk,” he said. “It is to be extremely diversified — and to invest in equities. You’re likely to do much better that way than if you stay out of the markets.”
Still, he concedes, it’s very easy to make the case that the factors affecting the stock, bond, currency and commodity markets are spectacularly harrowing at the moment.
Just consider some of the more obvious problems.
The prospect of Western military intervention in Syria has rattled the markets, sending oil and gold prices higher, driving down the value of emerging-market currencies and stocks and unsettling the stock and bond markets in the United States.
In Washington, the fiscal clock is ticking toward two irksome deadlines. At the end of September, the federal government will run out of money unless Congress takes action, and even if it does, the government will hit its debt ceiling in mid-October, the Treasury says. At that point, unless there is a meeting of the minds in Congress and the White House, the United States won’t be able to pay all of its bills, and it could default on its debt.
And in mid-September, the Federal Reserve is widely expected to begin reducing its $85 billion monthly purchases of fixed-income securities, in a move known as “the taper.” Longer-term interest rates have already begun to rise in anticipation.
The prospect of Fed action has sporadically unsettled the markets, playing a role in the sell-off of emerging-market debt and raising fears of a vicious feedback loop, in which bond prices, currencies and the real economies in countries like India, Turkey and Indonesia plummet and threaten to spread contagion elsewhere around the world.
This is not a pretty picture, and Kelly doesn’t claim that it is.
“We could have some very difficult moments,” he said. “The one thing you can expect is volatility.”
But in a trenchant summary of the prospects for investing under current conditions, Kelly said last week that the global economy had improved considerably since the collapse of Lehman Bros. five years ago. The economy is “more balanced” today, he said, with developed countries like the United States regaining strength and the world no longer needing to rely so heavily on growth in countries like China, India, Indonesia and Turkey.
Most important, relatively low interest rates have made stocks, as an asset class, more attractive than bonds. And he says “this should remain the case” even if interest rates rise over the next few years, as expected.
To be sure, people holding long-term Treasury bonds should expect to bear some losses if interest rates rise. (As I’ve noted recently, rates and bond prices move in opposite directions.) Ben S. Bernanke, the Fed chairman, has said that rates are likely to rise; that’s another way of saying that bond prices are likely to fall further, so investors should consider themselves forewarned.
But Kelly says that most investors shouldn’t be holding only long-term Treasurys — or only domestic stocks, or only cash, for that matter.
“If you perceive that risk is rising, then you need to be extremely well-diversified, because no one can predict which asset will rise and which will fall in any given time,” he said in a conversation last week.
He advocates investing based primarily on valuation, buying assets that are cheaply priced and are likely to rise, rather than on momentum, buying assets whose prices are already rising. Momentum works for a while — until the momentum shifts, which could happen at any time, leaving investors with overvalued assets that they may have to sell in a market rout.
“That’s not a very attractive strategy,” he said.
Current valuations suggest that developed-market equities are a better buy than developed-market bonds, Kelly said, and will remain so for several years even if interest rates rise. One valuation measure points this out: the difference between the yield on 10-year sovereign bonds, like U.S. Treasurys or German Bunds, and the earnings yield on equities. (The earnings yield is earnings per share divided by the current share price; it is the inverse of the price-to-earnings ratio, or P/E.)
Using this measure, the U.S. stock market remains quite attractive. The difference between the 10-year yield and the earnings yield is now 4.25 percentage points. German stocks are even more appealing, according to this metric, he said, with a comparable figure of 7.1 percentage points. And because he believes that both the German and U.S. economies are strengthening, Kelly favors overweighting investments in their stock markets while underweighting investments in their bond markets.
But, he said, he didn’t want “to oversell the probabilities of any one investment being successful in a given period of time.”
“All we can say is that based on history, some approaches are more likely to be successful than others,” he said.
And because it is very easy to be “wrong-footed” — to assume that an asset class is about to rise just when it is about to fall — a diversified and balanced portfolio should have bonds and stocks in a proportion that is appropriate for one’s individual needs and preferences.
Short-term risks like an expansion of the conflict in Syria or a spiraling currency crisis in vulnerable emerging economies could create turmoil in the markets, he said, but long-term investors should be prepared to ride them out.
“As a strategist, I am assuming that whatever happens in Syria, it won’t close off the flow of oil in the Persian Gulf, and that the markets will rebound quickly, even if they fall,” he said. “I have to make that assumption, based on past history.”
Short-term bets on the flow of oil or the direction of a currency like the Indian rupee aren’t likely to be productive for most people, Kelly said. Nor are investments in supposed safe havens such as gold, which he says is “the ultimate speculative asset, since it pays no dividend” and is useful only as a symbol of value in the eye of the beholder. Far better to make long-term bets on the growth of the economy, through diversified holdings of stocks and bonds. Even in risky times, he said, that’s likely to be a good long-term bet.