Friday, March 11, 2011

Price Appreciation, Retirement, and Income

“Don’t worry if the stock market is down, prices always recover.”  That widespread sentiment reflects the traditional emphasis on stocks—and stock-price appreciation—to provide the bulk of a portfolio’s returns to build assets for retirement.  Bonds provided stability and steady income.

But while stock prices may indeed always recover, they can take an inconveniently long time to do so.  If before stock prices recover retirement or a financial emergency occurs, for example, that can be a major problem.  And the odds of stock prices taking an inconveniently long time to recover are high when the entry point is high.  From the mid 1960’s to the early 1980’s, major stock indexes produced no gain in price.  Dividends were the only source of return.  Similarly, despite the doubling of stock prices over the last two years, the price appreciation on stocks during the last decade was only about 1% annualized.

So as the huge Baby Boomer cohort moves into retirement, private pensions are eliminated and government pensions are curtailed, there is even greater pressure on portfolio returns and steady investment income than in previous decades.  In addition, since house prices are generally no longer providing substantial appreciation—and instead will likely decline further—investment portfolios cannot provide extended periods of no price appreciation (unless there is high investment income). 

There are two investment sources to provide retirement resources—capital gains from price appreciation, and current income.  Considering the two traditional portfolio asset classes—stocks and bonds—conventional prospects are daunting.  Substantial, widespread capital gains seem unreliable from this point, despite the flat decade just passed.  Stock valuations are quite high on any basis except current-year earnings, which is no reasonable basis when profit margins are at historic highs (from unprecedented cost cutting and government stimulus measures).  On a cyclically-adjusted basis, valuations are quite high, as they are on a book value or dividend yield basis.  Bonds generally have completed a 30-year bull market, so further price appreciation prospects are similarly questionable.

That leaves current investment income to pick up the slack.  However, the dividend yield on stocks is only 1.8% on the S & P 500 Index, the 10-year U.S. Treasury note yield is about 3.4%, and the yield on cash is close to 0.2%.

With those paltry income returns, where can investors turn for sufficient income, growth of income, and protection of their asset base?  Fortunately for stock investors, the highest-yielding stocks are generally the most attractive segment of the market at current prices.  A number of health-care and communications services (particularly foreign) have substantial dividend yields and prospects for dividend growth to keep up with inflation.

Is it necessary to be concerned about future inflation, since inflation has not been a problem for some time?  Unfortunately, the wild experiment in monetary policy (especially in the U.S.), and probable further large increases in energy and agricultural prices, make protecting the “real” value of income and principal investments crucial.

Gold is a venerable form of money and inflation protection whose decade-long bull market seems intact.  But it is not an investment.  It is a form of money whose price has no investment basis.  Investments are based on the cash that is generated over time, which in the case of stocks provides resources for business expansion and the payment of dividends to owners.  Gold generates no cash flow, so a prudent portfolio that has at least a modest gold component will need to generate reliable cash from other sources.

One of the best sources of cash generation for investors is dividends and growth in dividends.  I’ve covered income-producing stocks in recent comments, such as high-yielding stocks and moderately-yielding stocks that have prospects for dividend growth (such as Abbott Labs—ABT).  In the bond market, inflation-protected government bonds might have some appeal for principal protection.  High-yield bonds, another potential source of high-current income, have recovered so sharply from the 2008 financial crisis plunge that their yield premium over U.S. Treasuries is now relatively modest.

In addition to income-oriented common stocks, there are three alternative sources of returns that deserve a prominent place in portfolios for the years ahead.  I'll comment more on those in my next posting.

Steve Lehman

S & P 500:  1301
Russell 2000:  802

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