Valuentum: Brian, thanks for joining us today.
Nelson: It’s my pleasure.
Valuentum: So the markets continue to make all-time highs. What are you telling investors?
Nelson: That depends. If you’re going to be in the market for more than 10 years, then you don’t have much to worry about. For long-term investors that are decades away from retirement and have absolutely no liquidity or income needs from their investments, one particular event resonates in my mind as to why they should have a full risk allocation to stocks. That event is the stock-market recovery from the Financial Crisis of 2008-2009 — which is the worst financial event of our generation.
In just 5 or so years after the credit crunch, the markets have completely replenished losses and then some. This is simply amazing. There’s little doubt in my mind that, for investors that plan to be in the market for 10 years or longer, their risk exposure should be all stocks. I don’t think we have a stronger historical case than the stock-market recovery from the Great Recession for this view. It was simply a cataclysmic time period, and yet, here we are at all-time highs in the stock market again.
Valuentum: But what about near-retirees or those in retirement that have income needs.
Nelson: The answer is much more complex. With market valuations as they are and with dividend growth stocks in favor, bargains have become harder to find. Within the next five years, it’s my view that near-retirees or retirees should expect a retracement in the markets to levels below where they are today. That said, we could hit 2000 on the S&P 500 (SPY) before we fall back. You can pick your own index, but I think you get my view of the potential trajectory investors should expect. We’ve stated previously that 1670-1680 is a more appropriate valuation for S&P 500 stocks (price is different than value).
The market is a forward-looking, discounting mechanism, and today, optimism about the future and liquidity is running wild. That means that today we have higher embedded long-term growth rates and lower embedded discount rates in stock prices. Over the next 5 years or so, we’ll likely see these two valuation drivers move against investors, as growth rates will be normalized following the recovery and interest rates likely approach longer-term averages. This isn’t anything to get too panicky about, but preparing for such a price trajectory will be important for near-retirees and those in retirement, especially if these investors have the opportunity to pursue alternative vehicles that may preserve capital while providing necessary income needs. If investors need to sell within the next 5 years or so, some profit taking could be a prudent idea.
Valuentum: Fascinating. If you believe the market will be lower in five years, why invest in it at all?
Nelson: I think this is where investors are sometimes too smart for their own good. Tactical moves in the stock market to tweak weightings here and there to reflect broader near-term market expectations can make sense at times, but strategic moves (or pulling all of one’s money out of a certain asset class) often turns out to be too aggressive. Many investors, us included, believe the stock market is starting to overshoot to the upside on the basis of traditional valuation metrics like the forward PE ratio, for example.
However, the very core of the Valuentum process embraces the understanding that markets undershoot and overshoot intrinsic value all the time. We’d only grow more pessimistic on the markets when they reveal a sustained move lower, confirming that momentum dynamics have soured. Selling at intrinsic value or higher often means missing out on continued pricing upside. This is how many value investors truncate their gains. Many pure value investors have already moved to the sidelines, missing most of the strong performance of 2013 and 2014.
Another important point is the concept of alpha. Though we expect the market to be lower within the next 5 years, we expect to outperform that nominal expected performance in the Best Ideas portfolio.
Valuentum: Interesting. So, even though you’re cautious on market valuation, you think long-term investors should still participate.
Nelson: Absolutely. That’s not to say that having some cash available isn’t prudent. In fact, we have meaningful cash balances in both the Best Ideas portfolio and Dividend Growth portfolio, and despite the cash headwind in a significantly strong up-market, we’ve been able to hold the line on the level of outperformance in the Best Ideas portfolio and put up some very impressive annualized performance in the Dividend Growth portfolio. This means that our ideas are outperforming the market, and the cash balance means the portfolio is less risky than the market.
Valuentum: Before you said long-term investors should be in all stocks, but you have a cash position in the portfolios. Why?
Nelson: That’s correct. Our risky asset allocation in the portfolios is all stocks and ETFs, which are collections of stocks focused on certain industry themes. We generally prefer stocks over fixed-income and other risky asset classes.
We’d view cash as a riskless asset, absent inflation considerations. Our cash position reflects a tactical view on market expectations and “dry powder” in the case that we decide to add new ideas to the portfolios.
For long-term investors, the Best Ideas portfolio and Dividend Growth portfolio contain ideas that may be excellent considerations for investors of various types. Many of our members follow the portfolios exclusively.
Valuentum: You had mentioned earlier that dividend growth ideas are in favor. Do you have any to share?
Nelson: Of course. We still very much like Apple (AAPL) and General Electric (GE) as underpriced dividend growth ideas for new money consideration. The iPhone 6 will redefine the screen size that consumers desire on their mobile devices, and while GE’s bid for Alstom has been somewhat of a distraction, we’re huge fans of the industrial conglomerate’s backlog trends and its plans for continued diversification away from risky financial operations.
We tend to prefer pure corporates in any long-term dividend growth strategy because they tend to be more transparent in their analysis and simpler for tax purposes. But for investors looking to take on the business-model risk associated with MLPs (master limited partnerships) and REITs (real estate investment trusts), Kinder Morgan Energy Partners (KMP) and Energy Transfer Partners (ETP) are two MLPs for consideration, while Realty Income (O) is our favorite REIT dividend growth idea. Realty Income is not called the Monthly Dividend Company for nothing. The tax consequences are different for investors when they venture outside traditional corporate entities, however.
Valuentum: Thanks for joining us Brian.
Nelson: Thanks for having me.
Nothing in this article should be viewed as financial advice. Please contact your personal financial advisor regarding your individual circumstances.