If you’re not confused by this topsy-turvy stock market, you should be.
Yet the big gains also seem surprisingly fragile. They have been driven, in large part, by huge advances in a handful of big U.S. tech companies that are expected to benefit from AI. Outside that charmed circle, earnings growth is fading, although optimism is growing about the possibility of a soft landing for the economy.
Depending on how you squint, you can see just about any message you want to in this muddle of conflicting signals.
Smart observers such as David Rosenberg of Rosenberg Research expect things to end badly when an inevitable recession finally hits North America later this year. Equally astute analysts such as Jan Hatzius, chief economist at Goldman Sachs, argue there will be no recession, neither in the United States nor in other developed countries, and investors are worrying needlessly.
So how does one invest intelligently at a time like this? Let me offer three rules that I have found useful.
The first one is to stop thinking that anyone knows for certain what is to come. Investing always involves some degree of uncertainty. Right now, the uncertainty is unusually high.
How stocks will perform over the next 12 to 18 months hinges on factors that nobody is good at predicting. The leading questions today include stumpers such as this: Will inflation continue to fade painlessly away? Will China restimulate its economy? Will home prices continue to shrug off higher mortgage rates? Will Donald Trump fight his way back to the White House?
Nobody can answer those questions with any great precision. So don’t beat yourself up if you don’t know the answers either.
That brings us to the second rule: Your primary goal as an investor isn’t to ingeniously predict the future, it’s to avoid obvious mistakes in the here and now.
The most common mistakes involve trading too much, betting money you can’t lose, investing too much in a single idea and paying too much for a hot stock.
The easiest way to avoid many of these problems is to diversify your stocks among different companies, different industries and different countries.
It helps to be a bit stingy, too. As a general rule, it makes more sense to invest in stocks when they’re cheap rather than when they’re expensive.
Stocks have historically traded for about 16 times their annual earnings. Right now, Canadian stocks are fetching about 14 times their expected 2023 earnings. U.S. stocks are going for almost 22 times earnings.
This suggests Canadian stocks may be a better deal than U.S. stocks. On the whole, that seems plausible. The comparison gets complicated, though, because a big reason why U.S. stocks are so expensive is that U.S. technology superstars such as Apple, Microsoft and Amazon trade at such lofty valuations.
Bears argue that the giddiness in the tech sector means the U.S. stock market is priced for perfection and vulnerable to decline. Bulls retort that the U.S. stock market has beaten other stock markets over the past decade primarily because of the superb performance of those tech superstars – and their performance shows no signs of fading.
The sensible thing, for most investors, is to hedge your bets. That means holding both Canadian and U.S. stocks, as well as international ones.
You should also pay attention to Rule No. 3: Don’t ignore bonds and other fixed-income investments.
A classic balanced portfolio comprises 60 per cent stocks and 40 per cent bonds. For much of the past decade, the bond component was an irritating drag on performance. Yields were so dismally low that investors made little or nothing in real terms after accounting for inflation.
Then came the debacle of last year, when interest rates and bond yields soared. Bond prices move in the opposite direction to bond yields, so bondholders sustained heavy losses. That came as a nasty surprise for anyone who saw bonds as a safe, low-risk investment.
No wonder so many investors now detest bonds. But they may want to think again.
Following the big run-up in interest rates, bonds are now offering some of their best yields in years. To be sure, those higher yields are offset at the moment by higher inflation. However, if forecasts are right and inflation fades back to 2 per cent over the next couple of years, the current 3.7-per-cent yield on a 10-year Government of Canada bond begins to look quite attractive for long-term investors.
To my eye, this is a fine time to buy bonds. If inflation and interest rates fall over the next year, bond prices will move in the opposite direction to those falling interest rates and chalk up solid gains. If not? Bonds still offer a solid, low-risk payout at a time when the outlook for the economy and stocks is highly uncertain.