The Fed has been cautious, announcing that it will begin tapering its bond purchases but promising to hold short-term interest rates low for a while. But it could be forced to act more rapidly if it deems inflation to have gotten out of control. Fed intervention set off the current bull market rally in March 2020, and it’s not hard to imagine that Fed intervention could end it.
Stock valuations are stretched.
The stock market keeps powering upward, and until that momentum shifts, it is hazardous to assume that the market will suddenly plummet. But its long rise has consequences: Most stocks are no longer bargains. As Robert Shiller, the Yale economist, has pointed out, an important measure of stock valuations, the cyclically adjusted price earnings (CAPE) ratio, has been hovering in a rarefied range, exceeded only in December 1999, during the dot-com bubble.
The Shiller index can’t predict short-term stock market movements, but, like other valuation measures, it suggests that stock market returns over the next decade are likely to be lower than those of the last one. Vanguard, for instance, projects that the U.S. stock market will produce annualized returns of only 2.4 to 4.4 percent for the next decade, in no small part because prices are so high.
Other world stock markets haven’t risen as much lately, and, partly for that reason, Vanguard expects that they will outpace the U.S. market by almost three percentage points, annualized, in the decade ahead. That’s a reminder that a truly diversified stock portfolio is a multinational one, containing shares from all major public stock markets (including those in China).
When stocks are terrifying.
The past is no guarantee of the future, but it provides clues. Countless academic studies suggest that the key to prosperity for nonprofessional investors is to hold stocks for the long term and avoid market timing.
That implies that investors need to be able to withstand big losses periodically because the stock market fluctuates, sometimes painfully, as it did last year. Recall that from Feb. 19 to March 23, 2020, the S&P 500 fell 34 percent. Further declines of that magnitude or greater could happen at any time.
Does that make you uneasy? It bothers me.
An excellent strategy for buffering losses and hanging on to stocks, come what may, has been to own bonds. That’s because bonds and stocks have been inversely correlated much of the time: When one rises, the other falls.
Read More: Buy Stocks to Prosper. Buy Bonds to Sleep at Night.