As stocks keep going up, focus on balance

The surprisingly relentless stock market has advanced steadily this year while setting record highs along the way despite a third and then a fourth pandemic wave.

Those remarkable gains have been driven by massive injections of fiscal and monetary stimulus into the economy. Pent-up demand and continuing stimulus create hope that stock markets will continue to push ahead with lots of momentum.

But not all indicators are favourable. Stock valuations are, by some measures, more stretched than they’ve been at any time since the tech bubble of the late 1990s. Also, a troubling bout of inflation may point to economic storm clouds just over the horizon.

As we head deeper into the fall, it’s a good time for investors to make sure their portfolios have the right balance to meet mixed conditions head on, although figuring out precisely what to do isn’t easy.

The financial media has been full of talk about the possibility of a fall stock market “correction,” which is a stock market price drop of 10 per cent or more that is usually short term. While occasional corrections are normal in an upwardly trending market, the relentless advance of stocks through 2021 has repeatedly staved off setbacks of that magnitude.

Every time there has been a modest market pullback this year, as there was early last week after the collapse of the Chinese real estate developer Evergrande, then that seems to trigger an influx of buyers eager to “buy the dip” at modestly cheaper prices, thus limiting the price decline.

What trends next

But beyond the possibility of a shortterm correction looms the larger question of whether the upward trend in stock prices can persist beyond the next few months for potentially the next several years.

A lot depends on what happens with inflation and interest rates. In recent months, inflation has been running higher than any time in well over a decade — in August, the Consumer Price Index rose 4.1 per cent compared to a year earlier. In order to maintain favourable economic conditions over the next few years, inflation and interest rates will need to stay reasonably tame.

The benign viewpoint held by many economists is that current inflation is related to reopening the economy and will prove “transitory.” These economists think the reopened economy

should achieve a reasonably steady growth path with the help of pent-up demand. That would allow central bankers and governments to gradually pare back monetary and fiscal stimulus. Under this scenario, interest rates should rise moderately and gradually (but not likely in a straight trend line) back to around pre-pandemic levels, which would be a bit higher than now but still low by historical standards.

If the economy realizes fairly strong growth while maintaining low interest rates, that would help governments, corporations and consumers cope with high debt levels without too much stress. Overall, if this viewpoint proves right, we should expect to get back to a steady state of economic prosperity without a major stumble. That in turn should support a trend of favourable stock market returns over the next few years, even if current high valuations make it improbable that we’ll see an outright stock market boom.

But it’s also possible that economic events won’t unfold so pleasantly. Some economists worry that inflation might become entrenched in expectations, which could make it harder to contain. If inflation continues at around four per cent or higher well into next year and beyond, bringing it under control might require a tougher response from central banks that leads to sharper interest rate rises. In turn, significantly higher interest rates would inflict financial pain on debt-laden governments, corporations and consumers, thus hampering growth. Under that scenario, a stumbling economy would likely lead to a period of poor stock market returns.

While most economists probably lean more toward a reasonably positive outlook, the darker scenario can’t be ruled out. Economic forecasts are only educated guesses, so it is prudent to position your portfolio to do relatively well under either scenario.

Mixing assets

A good place to start is with your asset allocation. These days, stocks drive most of your returns over the long term, but are also subject to periodic downturns. Relatively safe forms of fixed income don’t generate much yield now, but it stabilizes your portfolio when stocks do poorly.

The mix of 60 per cent equity and 40 per cent fixed income is a classic asset allocation that has long been used as a benchmark for investors with moderate risk tolerance investing for the long term. However, some investors will want less equity and others more based on differences in individual circumstances.

Paltry interest rates have caused many investors to shift their asset allocation in favour of more stocks. This issue has percolated for a few years but became a major focus of investment industry debate after interest rates plummeted to ultralow levels early in the pandemic. As a result, some balanced ETFs and mutual funds have upped their stock component from 60 per cent equity/40 per cent fixed income to 65 equity/35 fixed income or even 70/30.

Meanwhile, the steady stock market advance has gradually and increasingly stretched valuations, dampening some of the relative appeal of stocks. Fixed income may not give you much yield, but equities are far from a bargain right now. The upshot may be that the 60 per cent equity/40 per cent fixed income “classic” asset allocation isn’t as outdated as it may have seemed earlier in the pandemic.

Whatever your target asset allocation, it is likely the equity component has grown larger than target in recent months. If that’s the case, now is a good time to consider rebalancing.

Squeezing a little yield

On the fixed income side of your portfolio, the challenge these days is to generate even a small amount of yield without taking too much risk that undermines its stabilizing power.

One good approach is to invest more in corporate investment-grade bonds and less in top-rated government bonds. That way you get slightly more yield with fixed income that should still hold its value reasonably well during a stock sell-off.

You can also earn a bit more yield with GICs and high interest savings accounts at certain small financial institutions, rather than sticking with the big banks. But be sure to stay within deposit insurance limits. (You can compare rates online at websites such as cannex.com.)

The extra yield you can gain by either of the above strategies will depend on the particulars, but be warned that it is a small amount. In general, I would say you’re doing reasonably well if you can generate an extra percentage point of yield (100 basis points) using either approach.

There are other relatively risky strategies that can increase yields, but you need to be cautious about “chasing yield” at the potential expense of portfolio stability.

Longer-term bonds usually pay a little more interest than short-term bonds. But bond prices move inversely to interest rates and longer-term bonds are particularly vulnerable to rising rates.

So loading up on long-term bonds to get more yield could backfire if interest rates rise sharply.

You can also get a bit more yield going with high-yield bonds (also known as “junk bonds”). But they don’t pay you much extra yield for taking on a sizable amount of credit risk. Unfortunately, should a big stock market decline occur, high-yield bond prices typically drop much like stock prices, thus providing little stability to your portfolio when you need it most.

On the equity side of your portfolio, there are many different sound strategies for finding a good balance between risk and reward as part of creating a well-diversified portfolio. However, it is prudent to steer clear of the speculative end of the market in areas like meme stocks (such as GameStop and AMC) and some tech stocks where it is difficult to justify stock prices based on fundamental valuations.