Even with the recent increase in interest rates, bonds are still far overpriced in comparison to stocks. This is important to understand in managing your retirement portfolio. It is also important that you are well-prepared to lessen your overweight position in stocks, and increase your underweight position in bonds and/or CDs, as interest rates increase, as is very likely to continue to occur.
Currently, a typical investor should invest none of their speculative portfolio in bonds or CDs. Bonds and CDs are simply not attractive enough in comparison to stocks. Your speculative portfolio is any money you have in addition to your retirement portfolio, which is the money you are setting or have set aside for retirement living expenses. Many of us have no speculative portfolio, as we need or want all of our money for retirement living expenses.
Even today, bonds and CDs are a very important part of most high-quality retirement portfolios. The older you are, the more important bonds and CDs are. As you get older, simply owning stocks (and/or commodities, which should not be included in a retirement portfolio) is too risky. Bonds or CDs that can be held to maturity are, generally, safer investments than stocks. By owning a certain amount of bonds and/or CDs, you better ensure that a certain amount of money will available in the future when you need or want it.
Below, we will walk through some steps for determining how much of your retirement portfolio to invest in bonds or CDs.
The Bond Market: Current Expected Return
Below is an estimate of the expected return of the readily investable fixed-interest U.S. bond market. This estimate is far from perfect, but it is good enough for our purpose here. Sufficient data is not available for me to do this estimate nearly as well as I would like to. The estimate appears to cover about 91.7% of the fixed-interest bond market.
The estimate does not include CDs. There was insufficient data available to include CDs well enough. This is not very detrimental to this analysis in that CDs appear to constitute only about 4% or 5% of the fixed-interest bond and CD market.
For more information regarding the makeup of the bond and CD market, please see here. For more information regarding the estimate, please see the estimate itself―including the associated Notes. As you can see, the approximate expected return of the readily investable fixed-interest bond market is 2.33%.
The Bond Market: 2018 Expected Return
In order to know what price/earnings (P/E) ratio the stock market should be trading at to be fairly priced in relation to bonds, we need to project what interest rates will be in the future, after rates have normalized. With bonds expected to return 2.33%, it appears, on the surface, stocks should be trading at a P/E of about 43. However, interest rates are very likely to increase in the coming years. The stock market’s fair value is related to normalized interest rates―not the current (and temporary) unusual interest rates created by quantitative easing and other factors.
Below is an estimate of what the readily investable fixed-interest bond market expected return will be in 2018. This estimate is even more difficult to do well. We are attempting to predict something that cannot be precisely predicted, but predict we must.
The Stock Market: Current Fair Value
The projected-for-2018 5.78% expected return equates to a P/E of 17.3. About 18 is the figure I think we are looking for though. In brief, (1) Treasury should have a higher relative Weight in the future due to large U.S. budget deficits, (2) municipal bond spreads are currently relatively high, (3) I do not expect the Mortgage – Agency MBS YTW to be as high as projected, (4) we did not include CDs, which tend to be shorter-term and, hence, yield relatively less, and (5) the weighted average Shortest Maturity is over six months and, ideally, this would be shorter. All of these things influenced the projected expected return to be higher. On the other hand, I expect municipal bond default losses to be higher in the future than they are in the estimate.
Stocks: Overpriced or Not?
To determine whether the U.S. stock market is overpriced, we need to compare the (1 year) forward P/E for the stock market as a whole to 18. The forward P/E we need for comparison is not any of the forward P/Es you see quoted elsewhere though. Quoted forward P/Es are based on analysts’ estimated operating earnings. In recent years, based on S&P 500 data from Standard & Poor’s, total (GAAP) earnings have been about 90% of operating earnings. Also, quoted forward P/Es do not cover the entire stock market. Typically, they just cover the S&P 500. Also, there is a slight adjustment that should be made to account for the fact that stock prices tend to appreciate by earnings/price times one-plus-inflation. The inflation adjustment is due to the fact that companies, generally, increase prices over time (whereas bond principal amounts do not, generally, increase with inflation).
Sparing you the details, I can tell you that the true forward P/E for the entire stock market is about 16. With the inflation adjustment mentioned above, our fair value forward P/E is 18.36, versus 18. Fortunately, the stock market is not overpriced. If it was overpriced, we would need to do a more complicated analysis.
Bonds: How Overpriced Relative to Stocks?
Below is a calculation for how overpriced the bond market currently is relative to stocks.
The 63.2% figure should continue to shrink in the coming years as interest rates rise. As this 63.2% figure shrinks, you should lessen your overweight position in stocks and increase your underweight position in bonds and/or CDs. As you do this, you should realize some strong gains on your stock investments.
Retirement Portfolio Weighting Recommendations
Below is an updated table providing stocks versus bonds retirement portfolio weighting recommendations. These are general recommendations. They are not best for everyone. The table assumes that the oldest age you will live to, for retirement planning purposes, is 110. Also, to quote myself from my previous article titled “Strategies for the Current Low and Rising Interest Rates Environment”:
If you are young enough to fall within about the first third of the chart (below), at the present time, it is O.K. to own 100% stocks in your retirement portfolio. Some investors are uncomfortable investing in stocks or investing a lot in stocks due to the greater price volatility. If your retirement is or will be sufficiently pleasant without investing in stocks or investing a lot in stocks and investing in stocks or investing a lot in stocks will keep you from sleeping well at night or the like, it is O.K. to hold more bonds than the chart (below), or one like it, suggests or, even, hold 100% in bonds.
The analysis above did not consider taxes. This is because tax rates vary a lot among the many individuals and entities engaged in bonds and stocks investing. You should make adjustments, as warranted, in light of your specific tax situation. Foreign (non-U.S.) stocks and bonds were not considered either. Still, the analysis provides a lot of insight.
In making bond or CD investments, be certain to purchase individual bonds or CDs that you can hold to maturity; so you do not experience unnecessary losses in principal when interest rates continue to rise, as they will very likely do. Alternately, you can invest in a to-maturity-then-cash exchange-traded fund (ETF). I discussed these ETFs here and here. The yields of these ETFs appear to be significantly more attractive now that interest rates have increased some.