3 Reasons Why you Need to be in Equities

Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Markets are starting to roll over, with 3Q 2012 S&P 500 earnings on pace to record their first yearly decline in five years.  Follow this up with forward guidance from industry bellwethers that in many cases are downright scary (Apple, Amazon, Caterpillar, DuPont, and 3M to name a few), and no wonder the S&P 500 has declined 4% from its highs.  In fact, it is surprising it hasn’t given back more when one thinks about the current environment.  Electoral uncertainties are peaking, Europe is without a pulse, and a weakening Asian backdrop continues its march.  The U.S. is no happy place either, with core capex orders flagging recession alerts along with the fiscal cliff.  While all these factors matter to some degree, I think it just makes it easier for investors to flip-flop and start questioning their asset allocations on a daily basis.  Unless you actively turn your portfolio over, it is best to step back and assess the situation on a wider scale.  It is from this vantage point that maintaining a maximum equity allocation is the most prudent course of action.

Better than Bonds

This seems obvious, with 10-year Treasuries yielding only 1.75%.  Investors in Treasuries and corporate bonds will at worst suffer an opportunity cost and may realize negative real returns, but it isn’t a bubble in the sense that they will suffer a permanent loss of capital.  Bond funds, on the other hand, are where most retail investor money lies, and these can suffer permanent losses if interest rates revert to a more normal trend in the next ten years.  This won’t happen immediately, but over the course of a decade it is nearly a given that blue-chip equities will outperform their respective corporate bonds. 

United Technologies (NYSE: UTX) is one such blue-chip.  This company traces its roots back to 1934 and produces annual revenue in excess of $50 billion.  They recently acquired Goodrich Corporation to supplement their stable of brands that includes Pratt & Whitney, Otis Elevator, Carrier, and Sikorsky.  Investors can buy UTX and get a 2.7% dividend yield and realize 10 years of earnings growth, or they can invest in the company’s ten-year bonds and realize a yield of 2.31%. And how does the earnings-per-share growth over the last decade look?

<img src="http://media.ycharts.com/charts/6d5a5b79a6300554ccb4febe6af2c82f.png" />

UTX EPS Diluted Annual data by YCharts

Dow Jones Industrial Average member Caterpillar (NYSE: CAT) pays a 2.4% dividend yield, while its 10-year corporate bonds yield just 2.3%.  This isn't a high-yielding company with a payout ratio above 100% and flat growth outlooks.  This is a best of breed, blue-chip company with consistent, long-term growth opportunities.

<img src="http://media.ycharts.com/charts/15d9402c3e6eafed11421867307da9dd.png" />

CAT EPS Diluted Annual data by YCharts

Seasonal Factors Matter

November and December are historically good months for the stock market.  Do these factors matter?  Absolutely!  Take a look at the S&P 500 year-to-date and see how it compares to the average historical returns by month during election years (bottom).  It is amazing how close these two have tracked for the year.  Rally to start the year, pull back, rally to new yearly highs, pull back, but then what?  If history is a guide, investors should anticipate a year’s end rally and the S&P 500 to set new highs in December.


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Where is the Bubble?

This is the key concept that ought to keep the patient investor staying the course with a maximum equity exposure.  Where is the bubble that usually precedes key stock market tops?   The stock market, just like the business cycle, is about greed and fear.  Stability leads to instability.  Greed creates the feeling of a new normal and prices deviate widely from fundamentals- until they don’t.  The last three great stock market contractions were all set-up by a bubble. 

The S&P crisis in the 1980’s tried to capitalize on a massive housing boom.  This led to the recession and subsequent bear market that began in 1990.  The technology bubble was one for the ages and led to mind boggling valuations.  Cisco Systems (NASDAQ: CSCO) would see its price-to-earnings multiple exceed 300x.  The aforementioned United Technologies and Caterpillar would stay relative tame, with a peak P/E ratio of 32x.  Compare that to today, when Cisco yields 3.2% and trades at a significant discount to the S&P 500.  United Technologies has a current P/E ratio of 14x and Caterpillar has a ratio of 9x.  And lastly, the great global housing bubble that started to crumble in 2007.  The rise and fall of home prices and the resulting effect on the economy are still being felt today.

So where is the bubble now?  Absent a bubble and an over-reaching feeling of greed, it seems unlikely that the market faces another massive bear market that will send equities free falling.  Of course they will gyrate, and sometimes with scary corrections of 10% or more, but investors shouldn’t think another 50% market collapse is right around the corner.

Foolish Bottom Line

Stay the course with maximum equity exposure.  If you need to take a safer course of action, do so not by loading up on richly valued bond funds, but reallocate your equity holdings.  Pare back on emerging market and risky commodity plays such as Alcoa (NYSE: AA), which faces perils in controlling the Chinese supply of aluminum.  Shifting to a defensive U.S. company such as Beam (NYSE: BEAM) might make sense given the consistency of the company’s earnings and cash flow growth.  Whatever your risk tolerance, stocks remain attractive given good valuations, favorable calendar effects, and the complete absence of greed.

market8 has no positions in the stocks mentioned above. The Motley Fool owns shares of Beam. Motley Fool newsletter services recommend Beam. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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