Yes, it may finally be time to get back into stocks

Line chart illustrates the ups and downs of the Dow Jones industrial avergae over the past year.
By Steven Pearlstein
Washington Post Staff Writer
Friday, September 24, 2010; 1:53 AM

In early June 2007, while on my way to New England for my daughter's college graduation, I was reading through my usual pile of newspapers and decided I had seen enough evidence that a financial bubble was about to pop. After the plane landed in Boston, I made the first of several calls to mutual funds and brokers and sold all the stocks in the various accounts I manage for myself and my family.

It turns out it was a few months before the stock market peak, but as John Maynard Keynes once observed, it is better to be roughly right than precisely wrong. Since then, most of the money has been parked in money market accounts, one of which had the annoying habit of reminding us how little were were earning by mailing us a check for 56 cents each month.

Last month, as I was headed back to New England for a late-summer vacation, I happened to check my iPhone and saw that the Dow Jones industrial average had fallen sharply and was back near 10,000. I picked up the phone, called the funds and the brokers and put the money back into stocks - this time in shares of large, solid dividend-paying companies.

I'm not the first or the only person to reach this conclusion. A few days later, respected market analysts Jeremy Siegel and Jeremy Schwartz published a much-noticed essay in the Wall Street Journal arguing that dividend-paying stocks "offer investors more attractive income and inflation protection than bonds over the coming decade."

Although I'm generally a buy-and-hold investor - Washington Post rules prevent business writers from owning individual stocks or doing lots of trading - I've never bought into the conventional wisdom that you can't time the markets. There are times when it's fairly obvious that the market has pretty much played itself out, on the way up or the way down. My gut tells me this is such a time.

One good reason to be optimistic about stocks is that so many other people are so pessimistic. Since the beginning of 2008, individual investors have withdrawn $245 billion from stock mutual funds while pouring $616 billion into much-safer bond funds, mirroring similar strategies followed by pension funds and other professional money managers. That's certainly a reasonable response to a lost decade of stock investing that included two crashes in which prices fell by 50 percent or more. But at this point, the pendulum has swung so far that bond prices have risen to bubble levels, driving interest rates down to near-historic lows.

Interest rates are so low that the dividend yield on large-cap stocks is competitive with the yield on on investment-grade corporate bonds. Indeed, the yield on inflation-adjusted five-year Treasury bonds is actually negative; in effect, you are paying the government for the privilege of lending it money. Given that Federal Reserve's overnight lending rate is already at zero, it's hard to see how yields can go much lower or bond prices much higher.

As the bond bubble finally bursts, the smart money will move back to stocks or commodities. That's likely to happen at the first sign that the economic recovery is picking up speed, or the first time someone from the Fed hints that zero percent interest rates won't continue indefinitely. That could happen in two months, or two years, but when it does, things will happen very fast, which means you want to already be in the market rather than fighting the crowd to get in.

Until then, it is likely that stock prices will continue to fluctate without gaining or losing much ground, the perfect market for Wall Street's legion of short-term traders. If you look at the accompanying Dow chart from the past year, you'll see that every time the average has fallen to 10,000, a wave of computerized buying kicks in to push it back over the mark. Technical analysts characterize this process as putting a "floor" under the market. Given the level and rate of growth of corporate earnings over the past two years, along with the strength of corporate balance sheets, it would probably take a dramatic turn in business prospects for the economy and the corporate sector for this floor to give way and the Dow to fall below 10,000.

Indeed, right now companies in the Standard &Poor's 500 have $2 trillion in cash and short-term securities just waiting to be put to use. Given the excess capacity in so many industries, companies have been reluctant to invest much of it to expand, at least here in the United States. The other possibilities - using it to buy back shares or increase dividends or buy up other companies - all would have the general effect of pushing up stock prices. Some of that has already started and, given the herd instincts of most corporate executives, there is likely to be a lot more of it in the coming year.

In other words, going forward, the upside potential from owning stocks far outweighs the downside risks. The worst that is likely to happen is that stock prices go sideways for several years as the economy continues to bump along the bottom. And in the meantime, if you pick the right companies or the right type of stock fund, you can earn an annual yield that is at least comparable to what you can now earn from Treasurys or an investment-grade bond fund.

The bigger risk, it seems to me, is staying in bonds until interest rates begin to rise. If rates on 10-year Treasurys, for example, were simply to rise above 3 percent - still quite low by historical standards - the trading price of the bond would decline enough to offset the interest income. The only way to avoid a loss would be to hold the bond until maturity.

So the next time you look up and see that the Dow is down 200 points for the day, think of it as an opportunity to get back in the market. As I see it, the biggest risk to stocks right now is the prospect that radical Republicans might win control of Congress, setting up a political stalemate with a veto-wielding president that almost surely put an end to the Dow's 2,700-point Obama rally. But that is the subject for a future column.

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