The financial markets and the economy are entering new territory, creating new risks and opportunities for investors.
America’s slow recovery is gaining momentum, unemployment is declining and there are even signs that inflation will start to pick up. And while it will be years before before consumers and the federal government fully repair their broken balance sheets, housing prices recover and the majority of the unemployed get back to work, for the first time since 2007, the financial landscape is no longer defined primarily in terms of the crisis. The economy is moving forward.
As all economic transitions do, this moment of change is creating new possibilities in the financial markets. As the landscape shifts again, it’s important that investors understand where these opportunities are and where they can put their money. Here are 11 areas experts think you should consider right now:
As the global economic recovery accelerates, fears of deflation have been replaced with concerns about inflation. The prices of commodities and raw materials such as gold, oil and agricultural products have been rising for some time, but businesses have largely been unable to pass those higher costs along to consumers. That may change. While few experts believe inflation is likely to be a major problem, it can’t be ignored.
“We are not big inflation bears right now, but that is not the point,” says Seth Masters, chief investment officer for blend and defined contribution strategies at asset manager AllianceBernstein. “Even if there’s only a 10% or 20% chance that inflation becomes serious, that is a big problem for investors. It will be bad for stocks and very bad for bonds, so it makes sense to have some protection against inflation, even if that is not the central case,” he warns.
Real assets such as commodities can provide protection in an inflationary environment, says Kristi Mitchem, a senior managing director at asset manager State Street Global Advisers.
Rather than looking for the next hot commodity, invest in a broad range of commodities by tapping a mutual fund or an exchange-traded fund. “Investors should be well-diversified in commodities,” says Mitchem.
Allocation toward real assets will vary depending upon the age and risk tolerance of the investor, but Mitchem says something in the 10% to 15% range is probably suitable for a broad range of people.
Certain kinds of real estate investment trusts can provide a hedge against inflation as well, according to Masters. REITs that comprise 15-year leases may provide no protection at all. “But a hotel REIT that is based on room rates that can be adjusted as the market demands may be very sensitive to inflation, although that is not always the case,” Masters says.
3. Inflation-Protected Bonds
Inflation eats away at the value of traditional fixed-income securities, because the dollars you earn in interest aren’t worth as much as they were when you made the investment. Over the years, financial institutions have created a number of products that shield credit from the ravages of inflation. TIPS, or Treasury Inflation-Protected Securities, are one way to go about this. TIPS offer a fixed interest rate, but the amount of principal fluctuates, as does the actual amount of interest the investor collects. At maturity, TIPS should be worth at least as much as they were when they were purchased.
Investors can also purchase I-bonds, a form of savings bond in which the interest rate, not the principal, fluctuates over time. Step-up bonds, in which the interest rate rises every year, can be found in the corporate and government agency credit markets.
4. Australian Dollars
The U.S. Treasury market was a huge beneficiary of the global flight to quality during the financial crisis. Soaring demand drove down interest rates and funded the stimulus that helped bring America out of recession. But now, the Treasury market is saturated with supply — just look at the record $1.65 trillion 2011 deficit it’s funding — and demand as falling as the global economy recovers.
There are alternatives to U.S. Treasurys, though. “One way to hedge it is with the Australian dollar,” says Steve Persky, managing partner of Dalton Investments, a $1.1 billion hedge fund based in Los Angeles. Australia came through the financial crisis without falling victim to the credit pressures faced by the U.S. and much of Europe. Its debt-to-GDP ratio was an estimated 22% last year, compared to 59% for the U.S. Furthermore, its proximity to China and the other Asian growth markets is expected to help the country boost its GDP by 4.25% this year.
5. Municipal Bonds
Given the level of alarm about the municipal bond market, investors might wonder if putting money into this sector is akin to buying subprime mortgages in 2007. Yet most issuers in the municipal bond market will repay their obligations without any problem.
Muni bonds yields — say, 4% for 10 year bonds — are attractive, especially considering their tax-free status. The question is how to protect yourself from weaker issuers. John Taft, the CEO of RBC U.S. Wealth Management (RBC), says he prefers general obligation bonds and revenue-backed bonds that are linked to essential services such as water and sewer service, not special projects. Some experts suggest that larger issuers with higher ratings tend to be safer, but Taft believes that independent research by an investor or analyst before buying is key.
6. Large-Cap Stocks
In the midst of the financial crisis, investors fled the equity markets and credit prices soared. As the first signs of the recovery took hold, investors began moving back into stocks. The Standard Poor’s 500 is now at 1,330 — up nearly 100% from early 2009.
Yet there’s still opportunity in stocks, even if a market correction occurs. “Large-cap stocks are relatively undervalued,” Taft says. The SP 500 index of large companies is up 24% over the last 52 weeks, while the SP SmallCap 600 index is up 35% over the same period of time.
7. Dividend Stocks
Research shows that dividend-paying stocks tend to beat the long market. According to that theory, it’s always a good time to invest in them. Wharton finance professor Jeremy Siegel researched the SP 500 from 1957 through 2009 and found that the top 100 dividend stocks had an annualized return of 12.5% over the entire period, while the 100 companies with the lowest dividend yields returned 8.8%.
“Dividends are issued by quality companies that have a history of cash on their balance sheets — and they are often large-cap companies, which are currently undervalued,” Taft says.
8. Health Care and Consumer Staples
Investors who cycle out of the broad market in springtime and shift into defensive stocks such as health care and consumer staples tend to beat the market, according to Sam Stovall, chief investment officer of SP Equity Research Services.
The SP 500 has returned about 6.1% a year since 1995. But if this simple rotation — undertaken in April and lasting for six months — is employed, investors’ returns are boosted to 9.7%, according to Stovall. He says the results are even more pronounced among smaller companies. The spring defensive rotation boosts the return to 12.5%, compared to 9.7% for the broad market of smaller companies.
What accounts for this seeming mystery? Stovall says the broader market tends to perform better during the end of the year and late winter, thanks to the availability of bonus money, tax returns and other forms of liquidity. The rotation provides a defense against a traditional seasonal downturn for equities.
9. Stocks with Low Debt-to-Equity Ratios
If inflation picks up — as many experts believe it will — “investors may want to take a look at companies with low debt-to-equity ratios,” Stovall says. As the cost of debt capital rises, companies with cleaner balance sheets will have less exposure. The debt-to-equity ratio for the broad market is 51%, but several industries have much lower ratios, including tech, with a ratio of 28%. “Tech companies tend to become self-funding because their median profit margins are high, at 15.4% compared to 9.2% for the broad market,” Stovall says.
Other sectors with low debt to equity ratios include energy, with a ratio of 39%, and industrials, with a ratio of 46%.
10. Oversold Stocks
For the technically minded investor, some standards measures suggest when stocks are under- or oversold. The relative strength indicator (RSI), for example, tracks stocks’ performance over the last 14 days and ranks them on a scale of 0 to 100. Scores below 30 suggest that a company may be oversold.
Stovall said that as of Feb. 15, investors might want to consider these stocks with RSI’s under 30: Celgene (CELG), CVS Caremark (CVS), Dreamworks Animation (DWA), Family Dollar Stores (FDO) — now the target of a $7.6 billion takeover bid by investor Nelson Peltz — and Peoples United Financial (PBCT).
Finally, most experts say its wise to keep a certain amount of your assets in cash. “There is nothing wrong with keeping 10% or 15% in cash,” Taft says. “Warren Buffett always said to wait for the home-run pitch. That is how you make money.”
Tagged: Australian dollar, bonds, cash, Commodities, consumer products, consumer products stocks, Debt to equity ratio, dividend stocks, Dividends, health care stocks, Investing advice