The Best of Times/The Worst of Times

It was the best of times; it was the worst of times. This is what author Charles Dickens said of eighteenth century London and Paris around the time of the French Revolution. These same words could also be used to describe the current environment for investors in America.

The Dow Jones Industrial Average crossed the 15,000 threshold this year and remains not too far from its record high. This has been an astonishing turnaround of about 140% from the depth of the financial crisis in early 2009. Such a rebound has many investors paralyzed with fear of investing at the wrong time. A recovery is expected after a market collapse, but have we come too far too fast? Is it too late for those on the sidelines to get in? What is the proper valuation for the stock market? What can we expect in the months and years ahead?

Bond prices have been on a remarkable run of their own, also reaching new all-time highs. During my working lifetime, bond investors have been nicely rewarded. Unfortunately, Bill Gross, the best bond portfolio manager of our time, recently identified April 29, 2013 as the end of a thirty-year bull market in bonds.

Fueled by a long run decline in interest rates, bonds have enjoyed a fantastic ride, earning about 6% per year during the period. Most observers agree with Mr. Gross that interest rates have bottomed, so bond prices, which move in the opposite direction, have peaked. The financial media continually reminds us that we could be in the midst of a bond bubble. I think the dynamics are different than a traditional speculative bubble, but clearly returns for high quality bonds will be very poor in the coming years. Even so, what are the alternatives? Do you trade bonds for stocks and assume even more risk, or put money in short-term accounts earning essentially nothing?

Home owners have seen the equity in their homes evaporate over the last few years as a result of the financial crisis. The effect has devastated people with a small amount of equity as a percentage of the house value. However, homeowners with a paid off mortgage saw their net worth drop on paper but had no real change in their lifestyle.

Houses are selling at higher prices, and turning over more rapidly. It appears that the bottom has been reached and the worst is over but inventories of foreclosed homes and rising mortgage rates present strong headwinds for sustained price gains. Note that the commercial real estate market did not experience the same problems as residential housing. Covering a wide spectrum of income producing properties, the Vanguard REIT Index Fund, for example, averaged 8% per year in total return over the last five years and almost 11% per year over the last ten years. Homeowners might have suffered, but real estate investors have not.

Since the early 1980’s, inflation has been tame and most agree it will remain so for the next few years. At the same time, fears of future inflation are palpable. The Federal Reserve has been pumping money into the economy to keep it growing and to prevent deflation. The Fed vows to continue its quantitative-easing (QE for short) for as long as necessary, which will keep short term interest rates at essentially zero and long-term rates not much higher.

This is a dangerous game the Fed is playing. It will have to be very nimble as it tapers the financial stimulus to avoid igniting inflation. Investor fears can be seen in the rates for treasury inflation protected securities (TIPS), which until just recently were providing a negative return to investors after adjusting for inflation.

After languishing from the early 1980’s to the mid 2000’s, gold prices took off from about $400 per once as recently as a decade ago, to over $1,800 per ounce last year. However, late arrivals to the party were treated to gold prices plummeting to around the $1,200 per ounce level, a loss of about one-third. Gold is seen as a harbinger of future conditions. So which economic indicator should we believe the multi-year run-up in gold prices or the more recent nose dive?

We each might have an opinion about the future, but nobody can say with confidence what is really ahead for stocks, bonds, real estate, gold or the economy. Hindsight is like a pair of 20/20 eyeglasses, whereas predicting the future is more like looking through a cloudy crystal ball.

So, are these the best of times or the worst of times? The answer is probably based on your personal experiences as an investor and whether you are naturally optimistic or pessimistic. Either way, I can offer one piece of advice. Control what you can control and try not to worry about what you can’t control.

In The Tyranny of Compounded Fees, I explained the importance of keeping expenses low. Index funds make this easy and practical for everyone. Diversification and proper asset allocation between investment categories is totally within your control and can allow you to weather all types of market conditions. Even taxes to some degree can be managed through tax-efficient investing. Forgoing current consumption in order to save more for the future can also provide a margin for safety.

That said, and although we have great expectations as investors, managing costs, taxes and risk will not guarantee the best of times, but it will certainly give you the best opportunity to shape your own destiny.