This article is by staff writer William Cowie.
Visitors approaching Denver through the Rocky Mountains usually get a chuckle when they come through the last mountain pass and see these signs on flat stretches of highway:
They’re there for a reason: Looks can be deceiving. Truckers, when they get to the easy-going, think the rough stuff is behind them and that they can finally relax. When they encounter the first sharp turn on the 7-percent grade, however, it’s too late.
Don’t be fooled!
You may be driving along the investment highway, thinking you have finally made it through the rough years to some easy-going roads ahead — and your 401(k) and other retirement plan quarterly reports confirm that. This year you can expect to smile when you get your 401(k) plan report. The stock market hit new records last year and the bond meltdown some had predicted never materialized. Your contributions and the gains on your investments will combine to make your fund values look better than ever. But remember how you felt in 2009?
When you opened the envelope back in 2009, your fund values were in the toilet, and you probably felt awful, in two ways:
- The past: You felt like you had made all the wrong choices and you were just no good at investing.
- The future: You felt hope slipping away, ensuring that you would never have enough to retire.
Looking back, you’ll probably agree that was a bit of an overreaction. If you didn’t panic and stayed the course, your retirement plan has recovered much better than you may have thought possible. Your decisions weren’t that bad after all.
What will you feel this year?
- Relief: Whew, glad that’s behind me!
- Hope: Hey, at this rate, I may even be able to retire in style!
With the recession still fresh in your memory, though, you may have some lingering concerns: “I hope I don’t have to go through that again!”
Not to be an Eeyore about it, but you will. Like the highway sign says: “Don’t be fooled.” This nice ride won’t last. It never does. Those who had retirement plans in 2006 know what I’m talking about. The future looked rosy back then — stocks and bonds were both up, the economy was doing well, and home values were rising.
We know what happened. Reality hit hard.
Welcome to the economy. It moves in waves.
Does that make you feel discouraged, tempting you to say, “What’s the point of investing when the economy is just going to smack me down again when I least expect it?”
It shouldn’t. If you know morning traffic will be bad, what do you do? You plan around it. You leave earlier, try different routes, consider public transportation or buy a different house (like Holly and her husband did recently). The traffic is still there, but you can do something about it.
The same goes with the economy. Yes, it has its ups and downs, and that’s never going to change. But, like morning traffic, you can do something about it - if you check the traffic report ahead of time.
Understanding the “traffic report” for investing – how to read the signs
Most retirement plans are built on stocks and bonds. Like you would plan for a morning commute, let’s see if we can get a traffic report for investing.
Bonds: The bond market is several times larger than the stock market. This surprises most people, but most of the investment portfolios of the fabulously wealthy are predominantly bonds, not stocks. Bond prices are driven by interest rates. (If this is news to you, you can learn more here.)
Interest rates have been on a downward slope for about 30 years now, as you can see from this Federal Reserve chart:
That has led bond values to rise continuously for that 30-year period. If your retirement fund contained bond funds during this period, they did well for you.
But the road is going to turn again. The outgoing Federal Reserve governor, Ben Bernanke, assured us recently that the Fed will not raise interest rates until 2015. Still the chart tells us interest rates may have turned already. That means bond fund values are going to drop over the next few years. Yes, the funds get interest income, but those percentages are low, and the drop in fund value might wipe out those meager returns.
You can’t predict each morning’s traffic exactly, but you can look at trends and draw your own conclusions.
Stocks: The stock market dominated economic news in 2013 with record highs almost every month. Some believe the sky’s the limit, while others fear the market’s too high and about to crash.
Well, which is it? Nobody can tell the future; but just like the traffic patterns, there are some things you can learn. The first thing is the absolute number of the Dow doesn’t mean much. A Dow of 16,000 can be high, or it can be low.
The price of any stock or composite, like the Dow or S&P 500, is always expressed as a multiple of its earnings. It’s called the P/E ratio (Price/Earnings). Over the past century, the market’s P/E has averaged in the 13-to-15 range. The Dow and S&P 500 are almost identical in their histories and multiples, so tracking one of them is sufficient to get an idea of what’s happening. I happen to use the SPY ETF as a proxy for the market, which is easily tracked on any finance website like Yahoo.
The market’s P/E is currently hovering around 16. That’s only slightly higher than the historical average but nowhere near the levels of irrational exuberance (to use Greenspan’s term) that we typically see before a major crash (around 20 or so).
That means the stock market is not valued all that highly at the moment. If corporate earnings continue to rise at, say 10 percent, and the stock market rises in tune with those higher earnings, then a Dow of 18,000 could still reflect a fairly valued stock market.
Given that the economy is growing at the moment, we can expect rising earnings to power the stock market to new highs in 2014. That, coupled with an outflow from bond funds, will probably attract even more stock investors, which could drive the market even higher by increasing the market’s P/E.
All of this bodes well for the stock funds in your retirement plan. The naysayers may come out when the Dow hits 18,000 or some other arbitrary number. Your reaction should not be driven by the number but, rather, the P/E ratio behind that number. Once that creeps over 18 or so, that’s when it’s time to become nervous because, in a few years, the economy will do its usual thing and fall again. It does that like clockwork every seven to 10 years, and we’re almost five years from the last bottom. (I know, it doesn’t feel that long, does it?)
The long and winding road to retirement
The “traffic report” for 2014 investing looks good. You can expect nice feelings when you open the envelope this month. But, like the sign above, don’t be fooled — there is more rough stuff ahead. The good news is it looks like we may still have a year or two of sunshine to make hay.
The bad news… well, there is no bad news if you’re prepared when you take the wheel.
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