Yes, there are alternatives to stocks

THE stock market has been strutting into the spotlight lately, with talk – however premature – of a new artificial intelligence (AI)-driven bull market popping up nearly everywhere you turn.

Amid all the hoopla, you can easily miss the solid returns being posted by far less glamorous but always important and, at the moment, compelling asset classes: fixed-income investments, including bonds and cash.

Especially for those with short time horizons – whether you are in retirement or close to it, or saving for a house, education, a car, a vacation or any other worthwhile purpose – these lower-risk investments are worth a close look.

Until a little over a year ago, when interest rates were about as low as they could go, a mantra on Wall Street was Tina. It is an acronym for “there is no alternative” to the stock market, certainly not from fixed-income investments.

Now, though, it is a different world: Interest rates, or yields, have risen significantly. That is bad if you are borrowing, but if you have money to invest or stash somewhere safe so you can pay your bills, there are plenty of appealing options.

It is debatable whether it is wise to lock in higher interest rates now, or stick with shorter-term holdings until it is clear that the Federal Reserve is done raising interest rates. But the time to appreciate the benefits of fixed-income holdings like money market funds and Treasury bills is already here.

Even if you are just starting out in your first job, it is a good idea to try to keep an emergency fund in short-term, interest-bearing accounts. That is also true if you have reached a time of life when drawing down your assets, and making them last, are your main concerns. For the moment, it is possible to get safe returns that are beating inflation.

But stocks are booming

Still, the returns on short-term fixed-income investments are likely to be in the mid-single digits, at best. That is not going to make you rich. But a winning stock could.

There have been some rough patches in the stock market. Even so, the returns of Big Tech stocks have been fabulous. Nvidia, which churns out some of the chips that make AI run, was up 187 per cent for the calendar year as of Jun 28 . Apple, Alphabet (Google) and Microsoft were all up more than 34 per cent; Meta (Facebook) and Tesla gained more than 120 per cent. Wow.

But for high-flying tech stocks like these, timing is everything. Many are still down from the market’s peak on Jan 3, 2022. So is the benchmark S&P 500 index, which is why I am not confident this is a bull market for stocks, at least, not quite yet.

I am waiting for the S&P 500 to attain its old lofty level, before giving it the bull market designation. And even if the market reaches that pinnacle, I do not expect to be increasing my personal allocation to stocks.

Why? Two big reasons.

First, I never reduced that allocation when stocks were falling. I held on then because I could not predict where the market was going. (Wall Street prognosticators cannot do it reliably either, as a long history of failed forecasts shows.)

I am a permanent investor in both stocks and bonds. There is no need to increase the stock proportion of my portfolio now.

Second, I am not entirely happy about putting money into companies that are not producing profits sufficient to justify the investment. Take Nvidia. Its shares have lifted the returns of the S&P 500, but that is because it is trading at a lofty price. Its price-to-earnings ratio, which compares price to profits, is now uncomfortably high – about 10 times that of the S&P 500, according to FactSet data.

Essentially, Nvidia profits will need to soar for many years to justify the company’s price. Perhaps AI will make that happen. I am not counting on that, though.

So I am hanging in without great enthusiasm. History suggests that the overall stock market will rise over the long haul, but does not tell us anything about what will happen next month or next week, and it does not help much in deciding whether particular companies are worth owning. I will hold the entire market through index funds, but I am not eager to take extra risks with my hard-earned money.

That is where bonds and cash come in. They provide solid income with much less risk than stocks – in theory, anyway.

The effects of higher yields

It did not work out well for bonds last year.

At the start of the year, money market funds offered virtually no interest, and bond returns ranged from mediocre to terrible, depending on the month. Stocks were said to be the only game in town.

Interest rates rose as the Federal Reserve battled inflation, and the bond market cratered. Because yields (interest rates) and prices move in opposite directions, and yields started off at rock-bottom levels, soaring interest rates led to the greatest bond market losses of the last century. The Bloomberg US Aggregate Bond Index, a benchmark for investment-grade bonds, lost 15 per cent in 2022, according to FactSet. The S&P 500 was even worse, with a 20 per cent decline, though that was scant consolation if you held a lot of bonds, or bond funds, that you thought were safe.

Now, it is a different landscape.

Bonds are more reliable than they were last year because yields are already high. Even if they elevate further, there is a plush cushion now, and any potential price declines should be offset, and then some, by the income that bonds are generating. Bond mutual funds and exchange-traded funds are not likely to experience declines in last year’s range either.

“Bond math tells us it won’t happen,” Kathy Jones, chief fixed income strategist at the Schwab Centre for Financial Research, said in an interview.

With the federal funds rate above 5 per cent, rich yield has spilled into money market funds and Treasury bills of up to one year in duration.

Now that the debt ceiling battle is behind us, and the Treasury is issuing a huge amount of fresh debt, it is fair to say, once again, that those investments are safe. You cannot make that claim about tech stocks.

There are many ways of comparing the valuation of the stock and bond markets. It is a little wonky.

Basically, the higher the bond yields and the lower the stock earnings, the better bonds stack up, and vice versa. One long-standing metric involves comparing the trailing 12-month earnings yield of the S&P 500 with the yields of Treasury securities. At the moment, bonds are doing nicely in this horse race.

The S&P earnings yield is 4.34 per cent, according to FactSet, making it lower and, in some respects, less attractive, than the ultrasafe 5 per cent-plus yields on one-year Treasuries. Investment-grade corporate bonds are attractive, too. The yields on 10-year Treasuries are lower, well below 4 per cent, reducing their appeal.

What all this means is that Tina no longer applies: There are viable alternatives to the stock market right now.

These comparisons can go only so far. You are not likely to receive double-digit annual returns from high-quality fixed-income investments, while you might in the stock market. But the chances of losing a lot of money in bonds are lower, too.

A no-brainer

With yields above 5 per cent, money market funds have a powerful allure. They have been pulling in funds, with total money market assets in the United States exceeding US$5.8 trillion in June, according to Crane Data. Interest rates offered by the nation’s banks are rising, too, but generally trail those of money market funds.

The question, for opportunistic fixed-income investors, is whether it is time to lock in higher yields by holding bonds with durations of 10 or more years. I am not sure that it is.

The Federal Reserve has already told investors that short-term interest rates are likely to rise half a percentage point further this year. Rising yields would hurt the prices of current long-term bonds, as a matter of basic bond math.

On the other hand, the Fed’s monetary tightening could set off a recession, which, in turn, would be expected to lead to lower yields and higher prices for bonds.

This quandary makes the timing of fixed-income – as well as stock – investments tricky.

Jones suggests taking a “barbell approach”, with much of your investment in very short-term holdings and some of it in five-year bonds, either Treasuries or highly-rated investment-grade corporates. (A three-year Apple bond has a yield with more than a quarter percentage point premium over three-year Treasury notes, according to FactSet.)

I hold bonds mainly through broad index funds, just as I do stocks, owning a piece of thousands of securities throughout the United States and the rest of the world. How much in stock and how much in bonds – and in short-term holdings like money market funds or high-yield savings accounts – is a matter of personal preference. I do not alter my approach much, if at all, because of market shifts.

The only real change in my financial life in recent years, is that I moved much of my emergency money from bank accounts to money market funds, because of superior yields. But with inflation above 4 per cent, I try not to kid myself. Even at today’s interest rates, money market funds are barely keeping ahead of rising prices. That is why I keep putting money in the stock market.

But money market funds, savings accounts and, to a lesser extent, bonds, all serve a critical purpose. The money should be waiting, ready for use, even when the stock market is rocky. NYTIMES