Wednesday, March 16, 2011

Price Appreciation, Retirement, and Income (Cont.)

Last time I cited the rising pressure on portfolio performance.  The absence of house-price appreciation removes a crucial source of retirement resources, and demographic factors make further house-price depreciation likely over the next several years.  In addition, American workers are, on average, far short of the necessary resources for their retirements as the Baby Boomer generation is just beginning to move into retirement.  According to the Employee Benefit Retirement Institute, more than half (56%) of workers surveyed had less than $25,000 in savings and investments.  They have a long way to go.

For those investing for future and present retirement, where can they find opportunities to build a portfolio, generate income, and protect the portfolio and its income from unexpected inflation?  As a broad theme, emerging-market equities and currencies seem likely to offer above-average returns relative to developed markets in the years to come.  The countries generally have superior economic growth rates, low national debt levels, and favorable demographics.  Many also have natural resources that will be increasingly scarce.  However, after the more than doubling in most stock markets over the past two years, I suggest waiting for a correction.

Gold, as mentioned in the last post, offers inflation protection and protection against further declines in the U.S. Dollar, but it does not produce income.  And with capital gains even more unpredictable than in the past--or at least when compared to periods with attractive starting valuations--current income seems of critical importance.  After all, dividends historically provided nearly half of the total return from the stock market.  It's time once again to favor stocks with high current and sustainable dividends, as well as stocks with moderate dividends and prospects for dividend growth.

Besides large, multinational stocks, there are three other potential sources of income, income growth, and inflation protection.  First are master limited partnerships (MLPs).  They offer high income payouts, generally stable underlying cash flows, and exposure to tangible assets like energy pipelines.  Current distribution yields are about 5%.  The tax aspects are mixed.  The businesses are exempt from corporate tax.  On the other hand, the partnership taxation means that investors are taxed not on the cash distributions received each year, but on partnership tax computations, which add complexity and inconvenience to an individual's tax return.  I favor simplicity and would prefer to avoid the tax complexity.  Furthermore, share prices have risen sharply over the past two years and valuations based on cash-flow multiples are stretched. 

Another area is real estate.  Though residential house prices in the U.S. seem likely to fall further and a rebound looks well off into the future, commercial real estate has long-term appeal.  According to a recent Bloomberg report, the average “cap rate” on commercial real estate—that is, net income dividend by the market price—is about 7%.  If inflation rises in the years to come, both rents and property values should rise in turn.  Though I think the office and retail sectors face ongoing pressure, the unfavorable single-family home demographics are actually quite attractive for the apartment sector.  

The most accessible form of real estate is real estate investment trusts (REITs).  Unfortunately for new investors, REITs have rebounded sharply.  Apartment REITs, for example, typically had dividend yields of 7% or more a decade ago.  Now, they yield 3-3.5%, as the stock prices have risen on improved prospects for apartments (rents were up 4% on average over the past 12 months).  Until a price correction provides a better entry point for apartment REITs, health-care REITs that own senior housing or medical office buildings seem more attractive.  Health care REITs offer high dividend yields of 5-7% and prospects for moderate dividend and capital growth.  Foreign real estate stocks, particularly in Asia, would seem to have even better long-term prospects and would further diversify holdings of U.S. investors.

The other alternative is foreign bonds, particularly those of emerging countries.   Though the yield spread over U.S. Treasuries is now historically low, yields are still attractive (typically between 4.75-6% after expenses, using mutual funds or ETFs).  And for funds that hold bonds denominated in local (foreign) currencies, there are prospects for currency gains from appreciation relative to the U.S. dollar.  The dominant global currency role for the dollar is eroding, and prospects for emerging economies are excellent.  Emerging economies now comprise nearly half of global economic output, yet their stocks and bonds are significantly underrepresented in portfolios in developed countries, especially the U.S.  The long-term prospects for emerging market investments seem excellent; timing an entry point is the question.  This sector seems well suited for a dollar-cost averaging approach to building a sizable stake over time.  As with the other areas cited, gaining exposure to foreign currencies on a correction would be preferred as, for example, the Brazilian real has risen nearly 25% versus the U.S. dollar over the past year.  

These areas—high-yielding stocks, MLPs, REITs, and emerging market bonds–along with some gold (ETFs) for protecting against the consequences of monetary debasement--are areas to consider at a time of low (or no) yields and rising demands on current income and “real” capital protection.  But at the moment, I favor cash with some selective exceptions.

For those who can't bear holding cash at 0.2% these days, I consider emerging-market bonds and high-yielding stocks to be the most attractive asset classes based on both short-term and long-term considerations.

Steve Lehman

S & P 500:  1274
Russell 2000: 789

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