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As rally pushes prices higher, time to buy -- or save?

Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

The stock markets are shooting skyward and bond prices remain lofty. It's enough to put investors in a cheery mood as we approach the summer holidays.

But, with prices so high, I'm starting to wonder if saving might be for suckers.

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Don't get me wrong, I'm a frugal fellow whose heart sides with the industrious ants in the children's fable that has them weathering winter storms with aplomb. But we don't live in a world of fables. From time to time, opting for a touch of spendthrift indolence might be the right move; deferring more than a nominal amount of spending could prove to be costly.

To see where we stand, it's useful to consider what the markets offer to long-term savers.

On the bond side, long-term Canadian government real return bonds yield 0.5 per cent above inflation, according to the Bank of Canada.

On the other hand, simple long-term government bonds yield 2.5 per cent and don't offer inflation protection. If the Bank of Canada is able to achieve its inflation target of 2 per cent over the long term, both types of bonds are likely to reward savers with roughly the same real gain.

When it comes to stocks, the situation is a little better. I like to use the past as an admittedly rough gauge of what to expect. To do so, I turn to Professor Robert Shiller's cyclically adjusted P/E ratio, which is based on the current price of the S&P500 divided by its average inflation-adjusted earnings over the last 10 years.

Prof. Shiller's P/E ratio is currently near 23.3. It's quite high compared to the historical record, which stretches back to the early 1880s. Indeed, it has only been higher 11 per cent of the time.

If you look at past periods with similar P/E ratios (say between 21.3 and 25.3), the returns over the decade that followed weren't great. Real returns over the next 10 years averaged 1.7 per cent. Mind you, that average hides quite a bit of variation. For instance, about 43 per cent of the time, investors lost money over those 10 years.

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The record suggests that U.S. stocks are likely to provide modest inflation-adjusted returns – perhaps about 2 per cent annually – over the long term with a huge side order of volatility. Regrettably, the prospects for Canadian stocks aren't much better. (Those with more adventurous appetites might do well to look overseas.)

Most portfolios contain both stocks and bonds, with a 60-per-cent stock and 40-per-cent bond mix being fairly common. Assuming real returns of 0.5 per cent on the bonds and 2 per cent on the stocks, a balanced portfolio would return about 1.4 per cent annually, after accounting for inflation, over the long term.

That's not much to write home about and even the modest gains will come with some bumps along the way. Even worse, I've not factored in fund fees, commissions, or income taxes into the mix.

Regular fund fees alone can turn modest expected returns into losses. For instance, the median open-ended Canadian equity balanced fund charges an annual fee of 2.2 per cent according to globefund.com. That's well in excess of the expected real returns.

The silver lining for savers is slim. They might be able to eke out modest real gains over the long term provided they keep expenses to a minimum and don't blow the budget on antacid during the ride.

Despite the poor odds, I'm not prepared to stop squirrelling money away. But spending a little more today has become much more attractive – at least until long-term investments become less expensive.

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