Take the money and run or keep your allocation to stocks?

I’m sure this is a question many of you have. The market has had a good run so far this year, with the S&P 500 gaining 17.3% on a total-return basis through yesterday’s close, despite a long list of worries. Then there is the old adage of “sell in May and go away.” But, Mr. Market remains in a chipper mood as is evident by the new record closes continually being set by the Dow Jones industrial average and the S&P 500.

So, should you stay or should you go? The answer is yes.

If the above response seems to have all the clarity of a response one would expect from a politician, allow me to elaborate. The current environment does not offer any good alternatives from an allocation standpoint. Cash is earning next to nothing in absolute terms and costs you wealth on an inflation-adjusted basis. Yields on the benchmark U.S. Treasury closed yesterday at 1.94%. Even gold is no longer glittering from an investment standpoint.

Relative to bonds, stocks remain cheap. The earnings yield on the S&P 500 is 5.8% as of Wednesday’s close, a significant premium to the current yield on bonds. One could argue that stocks are no longer cheap with a trailing price-earnings ratio of 17.1, versus the average P/E of 16.6 since 1960, and a current cyclically adjusted price earnings (CAPE) ratio in excess of 23, but bonds are expensive too. On a valuation basis, by switching from stocks to bonds, you would simply be exchanging one not-so-cheap asset for an expensive asset. Cash not only loses out to inflation, but also incurs opportunity costs.

One of those opportunity costs is the chance that stocks will be priced higher in six months than they are now. Though the period of May through October is referred to as the “worst six months,” the S&P 500 still boasts an average gain of 1.2% since 1945, according to Sam Stovall at S&P Capital IQ. It is also helpful to consider what your potential loss might actually be. To throw out some numbers for the sake of discussion, let’s assume a summer correction hits and stocks pull back 10%. If the current momentum lifts the market another four percentage points between now and its late spring/summer peak, the actual decline from today will be a little more than 6%. Though nobody likes to see their portfolio decline in value, a 6% pullback is well within the range of normal fluctuations and should not be any cause to sell or worry. Keep in mind that this is just an example. When I asked my Magic 8 Ball if the market’s returns will be better or worse than what I just typed, its response was “As I see it, yes.”

It’s not just my Magic 8 Ball that is giving a lack of clarity. Jack Schannep of the TheDowTheory.com Newsletter sent out an alert last week saying the Dow Jones transportation average’s break to new record highs warranted an “in the clear” signal. He further added, “As an ‘old bold pilot’ the implication of rising above the clouds and being ‘in the clear’ is favorable, but not necessarily a permanent situation—there are usually other clouds, and some may rise into your flight path.”

Confusing? Yes. Uncertain? Yes. But, if correctly forecasting where stocks are headed was easy, the long-term returns on stocks would not be 9.98%; rather they would be much lower. Over time, stock investors get compensated for incurring risk.

If you are concerned about how stocks will perform over the next six months, you could rely more on dividend-paying stocks, whose stream of income helps to cushion the blow of falling stock prices. Just pay close attention to valuation if you are seeking stocks in traditionally less economically sensitive sectors. Yields on health care and consumer staple stocks are down far more on a year-over-year basis than the yields on energy and technology stocks are, as we noted in the May AAII Dividend Investing newsletter. For stock hunters, these differences mean you may find more attractive valuations by looking at technology and energy stocks.

Keep in mind that this discussion is specific to the tactical question of whether you should allocate out of stocks because the best six months period is now over. Maintaining long-term allocations to bonds and cash still makes sense from an overall portfolio allocation standpoint.

More on AAII.com

• Charles Dow’s Theory Still Valid for the 21st Century – Jack Schannep explains what Dow Theory is and how to use it to analyze market trends.
• How to Take Your Emotions Out of the Sell Decisions – A good, but often overlooked, way to manage portfolio risk is to stay disciplined with your sell decisions. Jim Norris explained how in this 2002 AAII Journal article.
• Do You Trade off of Seasonal Factors? – Tell us on the AAII.com Discussion Boards.
• AAII Sentiment Survey – AAII members are slightly less optimistic and slightly more pessimistic about the short-term direction of stock prices.
• Don’t forget to take the Sentiment Survey.

Model Portfolios Updated

There were no transactions in either of the Model Portfolios during the month of April.

Last month, the Model Shadow Stock Portfolio gained 1.8%, outperforming the Vanguard Small Cap Index fund (NAESX), which gained 0.1%, and bettering the DFA US Micro Cap Index fund (DFSCX), which was down 0.8%. Year-to-date, the Model Shadow Stock Portfolio has gained 24.7%, beating the Vanguard Small Cap Index fund, which gained 13.0%, and the DFA US Micro Cap Index fund, which was up 11.2%. The Model Shadow Stock Portfolio has a compound annual return of 17.5% from its inception in 1993, while the Vanguard Total Stock Market Index fund (VTSMX) has gained 8.7% annually over the same period.

The Model Fund Portfolio was up 1.1% for April. This compares to a 1.7% gain for the Vanguard Total Stock Market Index fund (VTSMX). Year-to-date, the Model Fund Portfolio has now gained 11.3%, compared to 12.9% for the Vanguard Total Stock Market Index fund. The Model Fund Portfolio has a compound annual return of 8.8% from its inception in June of 2003, while the Vanguard Total Stock Market Index fund has gained 8.0% annually over the same time period.

• Picking the Right Stocks Using Charts – For those of you looking to take advantage of the market’s current momentum, charts can reveal which stocks have the strongest upward trends.
• The Covered Call: An Income Generating Options Strategy – For those of you who are nervous about the market, covered calls can provide income to partially offset downside risk.
• How Do You Stay Focused on the Long Term? – Tell us on the AAII.com discussion boards.
• Don’t forget to take the Sentiment Survey.

The Week Ahead

The final two Dow components, Home Depot (HD) and Hewlett-Packard (HPQ), will report on Tuesday and Wednesday, respectively. Joining them next week will be more than 20 other members of the S&P 500. Included in this group are retailers Target (TGT) and Lowe’s Companies (LOW), both of which will report on Wednesday.

The economic calendar will be quiet until Wednesday when April existing home sales and the minutes from the last Federal Open Market Committee meeting are published. Thursday will feature April new home sales. April durable goods orders will be released on Friday.

Federal Reserve Chairman Ben Bernanke will speak publicly on Wednesday.

The Treasury Department will auction $13 billion of 10-year inflation-protected securities (TIPS) on Thursday.

AAII Sentiment Survey

Individual investors are slightly less optimistic and slightly more pessimistic than they were a week ago, according to the latest AAII Sentiment Survey. Even with the changes, the sentiment readings are close to their historical averages.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 2.3 percentage points to 38.5%. The decline puts optimism below its historical average of 39.0% for the 10th time in 12 weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 0.4 percentage points to 32.2%. This is the fourth consecutive week that neutral sentiment is above its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 1.9 percentage points to 29.3%. This is the first time pessimism has risen in five weeks. The historical average is 30.5%.

All three measures of sentiment are near their historical averages. The bullish sentiment readings reflect the ongoing record highs being set by the Dow Jones industrial average and the S&P 500 index, better-than-forecast earnings, signs of continued economic growth and a lack of new bad news. Keeping some investors cautious or pessimistic are current valuations, the actual pace of economic growth and a lack of progress on key issues by the White House and Congress.

This month’s special question asked AAII members if they are holding onto stocks they think are overvalued or overbought. Close to 40% of respondents said no, they are not. Nearly a third of respondents, however, said they were. Dividends were the primary reason given as to why respondents were holding to stocks they thought are overvalued or overbought, followed by an adherence to a long-term investment strategy. A couple of respondents opined that there are not any good alternatives to stocks right now.

Here is a sampling of the responses:

• “No. I sell stocks that I think are overvalued and I buy on dips.”
• “I’m holding onto a couple that are probably priced over fair value because of their dividend yield.”
• “Yes, since I may well be wrong about the valuation. I am a long-term investor, so I don’t play my short-term guesses.”
• “Where else would I put the sale proceeds?”