As some of the uncertainties surrounding the economy lift over the course of the year, attention is bound to turn back to the fundamentals of the private sector, says Katherine Nixon, chief investment officer for the Northeast region at Northern Trust.
And on that front, things don’t look so bad. Corporate profits are hanging tough. Yes, growth has been slowing noticeably in recent months, but earnings for firms in the S&P 500 are still expected to climb an above-average 9% next year, according to S&P Capital IQ.
As for whether stocks represent a good value now, the picture is decidedly mixed. A conservative measure of price/ earnings ratios — which relies on 10 years of averaged earnings — would suggest equities are too expensive to load up on. But the S&P’s P/E, based on projected profits, points to stocks being a decent buy. “Anyone willing to take on volatility and invest in equities today with a three-year time frame should see large positive returns,” said Chuck de Lardemelle, a co-manager of IVA Worldwide Fund.
Meanwhile, interest rates are near all-time lows. That’s good news for stocks, but fixed-income investors will have a tough time making money. Tom Atteberry, manager of FPA New Income Fund, notes 10-year Treasuries were yielding less than 2% in the fall. At that paltry level, a fraction of a percentage point increase in rates could wipe out what little your bonds are yielding — and then some. Yet economists think 10-year rates will climb modestly. So it will be critical to diversify your bond portfolio into other areas, in particular, corporate debt.
The action plan — In a market likely to produce only modest gains, diversify your fixed-income bets and focus on relatively safe equities.
Stocks: Ride the big dependables. Early on in a recovery, small-company stocks traditionally give you the biggest pop. At this stage, it’s the big boys with balance-sheet might that are likely to outperform, as was the case in 2011. Not only do large firms provide greater exposure to foreign markets — including emerging economies that are growing much faster than the U.S. — their bigger dividends can account for a sizable portion of your gains in a low-return year, says Northern Trust’s Nixon. Funds that pay particularly close attention to high-quality blue chips are Jensen Quality Growth and T. Rowe Price Blue Chip Growth. Both are on the MONEY 70, our recommended list of mutual funds and exchange-traded funds.
Seek out revenue growers. Brad Sorensen, director of market and sector analysis at the Schwab Center for Financial Research, expects businesses to upgrade technology to boost productivity. It’s already happening. In the third quarter, business spending jumped 16.3%. Another area likely to enjoy better-than-average revenue growth is the industrial sector, where firms are seeing strong demand from emerging markets building out their infrastructure. For an added dollop of tech, go with the Vanguard Information Technology ETF, which bulks up on tech giants like Apple and IBM. For industrials, check out iShares S&P Global Industrials.
Bonds: Bet on high yield. As recession fears rose in 2011, economically sensitive high-yield bonds sold off bigtime. Result: The gap in yields between “junk” bonds and short-term Treasuries jumped to more than nine percentage points, up from six points in early 2011. “That spread represents a pretty good value,” says Robert Ostrowski, in charge of taxable fixed-income strategy at Federated. LPL Financial market strategist Anthony Valeri says junk is trading as if defaults will spike to 9%, up from 2%. “We just don’t see a 9% default rate as remotely likely,” he says. Given junk’s tendency to bounce around, Valeri recommends keeping a modest stake of 5% to 10% in these bonds. You can accomplish that through a diversified junk fund like Fidelity High Income.
Don’t get stuck in the middle. On the other end of the fixed-income spectrum are Treasuries, which won’t default but are at risk if rates rise. Treasuries maturing in five to seven years are paying barely more than cash, so it makes little sense to buy them. Ostrowski recommends a “barbell” strategy, with 80% of your Treasuries in short-term securities and 20% in long-term bonds. He says the Fed’s campaign to buy long-term Treasuries, dubbed Operation Twist, should make long Treasuries less of a risk. And this strategy could yield around 2.5%, nearly a point more than what seven-year Treasuries are paying.
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