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Cheap Money, Expensive Stocks – What Now?

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It has been hard to ignore, or escape, the relative volatility that has turned the stock market into a veritable hot potato over the past several months. Not to be outdone, however, has been the fixed income space, where interest rates have also traded in a zig-zag manner with no conviction for some time now.

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While investors may view low interest rates as a reason to avoid bonds altogether, the ZIRP environment has been a boon for borrowers. With money so cheap, consumers have good reason to get into a first-time home, a car, or even start a new business.

Though the glass has been half-empty quite some time now for those who wish to build a secure retirement income on “safe” investments, the glass has been half-full for those just starting out or otherwise needing access to cheap capital.

Predicting the near-term direction of interest rates more times than not turns out to be a fool’s errand, just as predicting what a stock might do over a 5 minute period. Still, having an inclination one way or the other can assist the investor in how to allocate capital within a portfolio.

For instance, if you think the 10-year Treasury will bounce off the 2 percent mark where it currently sits and moves to 3% by the middle of next year, it wouldn’t be a good idea to buy any kind of long-term bond. On the other hand if you see a move towards 1% over the next 12 months, than it would make perfect sense to buy all the multi-decade paper you can right now.

Of course if you are wrong about either of the above scenarios, you could end up seeing a great deal of paper loss or, minimally, opportunity cost. Thus doing something variably in-between the two extremes is generally the better option.

How investors should view interest rates is really nothing different than how they should view stocks. Given that no one has a crystal ball, decisions should be made based on the current macroeconomic environment, the business prospects and valuation of the security being considered, and a general inclination on what “will” happen going forward should all be contemplated before allocating capital.

Throwing spaghetti at a wall and hoping it will stick may work from time to time, but over the long-term a mindless investment strategy isn’t likely to be palatable, or profitable.

Facing Today’s Investment Challenge

Portfolio building continues to be a difficult exercise for investors in all age categories. Retired investors who would have preferred to be in insured CDs or municipal bonds, are increasingly viewing equities as an income solution. Though this has been a wise decision for the better part of the past half-decade, this year’s flattish, volatile market should be a reminder of the pitfalls of stock investing. This is especially true for those that have admittedly increased portfolio risk in the face of the income drought.

The younger investor trying to pick attractive equity entry points may have come across a few land mines over the past year and, as a result, become a bit gun shy in the process.

With the 10-year at 2%, as we touched on above, investors may be wise to consider whether 1% or 3% is the next stop. While rates will be still be “low” in either scenario, the move will represent a 50% move. Being right and positioning a portfolio accordingly would be a boon, while being wrong could be a painful prospect.

On the equity side, it appears it you blinked over the past two weeks, you missed your chance to buy the recent double-digit market dip. With a meaningful retracement having occurred already, it may not be worth chasing your favorite stocks, especially with tax loss season starting to come into focus right now.

Specifically speaking, I would not go much beyond intermediate duration bonds and would not get cute with junk bonds, since the global economy seems to be teetering on recession.

On the stock side, despite the valuation, I would overweight domestic equities, especially those that are insulated from overseas currency, oil price, and general revenue growth issues. IJR – a small cap ETF from iShares might be a good pooled choice. For income seekers, I like REITs that own upper end apartment dwellings – MAA and APTS are two ideas there.

Adam Aloisi was long shares of IJR, MAA, and APTS at time of writing, but positions can change at any time.

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Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.