Are There Any Attractive Alternatives To Stocks and Bonds?

Stock markets have given investors a serious roller coaster ride for the last 18 months with little to show for it. The large company weighted SP 500 is roughly where it was in January 2018. Unfortunately, the average stock has fared quite a bit worse. The Value Line Geometric Index, an equal weighted index that provides a pretty good representation of all available stocks domestically is down about 15% over the past 18 months (see below).

The mega stocks are holding up but it’s hard to get overly excited about the stock market from a value perspective. Broad based stock market indexes are trading at very high levels historically.  This may create a headwind of sorts going forward.

Below is the Buffett Indicator. It represents the price of the broad stock market relative to US GDP. Currently only slightly below levels reached during the late 90’s tech bubble.

What about bonds? Unfortunately, bond yields have gotten so low that buying them for income is virtually nonexistent. Buying bonds today is mostly a bet that rates will continue to fall.  The ten year treasury is currently sitting at about 1.65%. This is with inflation running officially at about 2%. Incredibly, many government bonds overseas are trading with negative yields. Investors are actually paying to lend someone money!

Of course, bond yields could stay low or continue to decline which may make stocks look relatively attractive, hence driving good returns for both. That may indeed be the case in the future. That said, risk is fairly high in both asset classes.

While no one knows the future, we can look for areas of value that are present today. Two areas look pretty attractive for patient investors: commodities and small value stocks.

Commodities/Hard Assets

Owning assets in the commodities space is investing in raw materials such as agriculture products like wheat, energy (oil or natural gas) or metals (gold, silver, copper).  At times, owning commodities can provide excellent diversification benefits to a portfolio of stocks and bonds.  (For example, in the 4th quarter sell of last year, the market declined by double digits but gold increased 7%.)

We believe over the next several years commodities will perform well.  Why? A couple of reasons. First, commodities are cheap relative to financial assets (see below).

Many of these assets are under owned, unloved and are incredibly cheap.  We are currently fans of US pipeline companies. These assets pay a high, sustainable yield which is expected to grow over time and are absolutely crucial to helping our country supply energy. What’s more, they are substantially cheaper than other hard assets like real estate and utilities. See below from Global X:

Secondly, the supply-demand scenario looks attractive.  Many companies in the commodity space have dramatically reduced production. When commodity producers don’t make money they shut down projects and/or go out of business.  What’s more, demand will continue to rise for commodities.  World population continues to grow and everything from food to energy is vital for us humans.

Finally, commodities can be a good inflation hedge.  One can debate whether or not we will have high levels of inflation in the future. But if we do, it will likely be a difficult environment for stocks and bonds and positive for commodity prices.

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Small Value Stocks

This bull market in stocks is similar in many ways to the dot com boom of the late 90’s.  Many of the stocks that have done well tend to be tech oriented growth companies with little to no earnings. This has left small, value oriented stocks very cheap on a relative basis.

According to Larry Swedroe at Advisor Perspectives:

U.S. large and small growth stocks have price-to-earnings (P/E) ratios that are above their 20-year averages at 101% and 116%, respectively, and the P/E ratio of U.S. large value stocks is close to its 20-year average at 97%, the P/E ratio of U.S. small value stocks is well below its 20-year average at just 84%. The decade-long underperformance has led to a widening of the spread in valuations.

From a historical perspective, small value stocks look cheap.

What’s interesting to note is that companies that are performing well financially have seen their share price languish. The chart below shows us that companies with over 10% returns on invested capital have seen their share price fall relative to the broader market. In a sense, the market has been rewarding money losing companies over winners. We believe it is only a matter of time before common sense returns.

It’s important to note that commodities and small value stocks tend to be volatile and may not be appropriate for all investors. Make sure your allocation to these assets makes sense given your goals and risk tolerance and consult your financial advisor for your unique situation.

About Michael McGinley, CFP®, AIF®

Michael McGinley has worked in the financial services industry for over 15 years. He is currently a partner at Providus Advisors, an investment advisory firm located in Chandler, AZ.

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