Fasten your seat belts -- it's going to be a bumpy ride. This warning comes courtesy of Rex Macey, chief investment officer of Wilmington Trust Investment Management. Macey says it's very important for investors to be patient and careful these days, understanding that a lot of things can happen. "We are in a time, I think, of unparalleled uncertainty -- [there's] no easy money that I see out there," Macey says. "This is a time to cover your bases to be more at strategic levels. I think successful investors wait for the right opportunity."
No longer can we expect that any stock in any sector -- from Abercrombie & Fitch
One reason for a volatile stock market is the state of the economy. Macey says the U.S. is in a recovery ("There are green shoots. Things are less bad"), but he characterizes it as weak. He says he thinks earnings are getting better, but that this is thanks to cost-cutting, which includes a reduction in labor. "That's not good for employment and consumer spending," he says.
Because we experienced a recession coupled with a financial crisis, Macey foresees a slow economic recovery. Even though the financial system has stabilized, Macey says, credit creation and credit demand haven't returned to previous levels. Americans are still paying down credit. "Without that credit, we don't have the growth we would normally have coming out of a recession," he says. "We have a real-estate overhang and high unemployment. These are tough things to tackle."
He says he also worries about the Federal Reserve potentially raising rates later this year, which could be tough on the market: "The government is doing everything it can to keep rates down, but that's going to come to an end at some point."
Single-digit returns for the next seven years
Macey just completed his seven-year forecast, in which he calls for single-digit returns for stocks. Based on current valuations, Macey projects that large-cap equities will return 7.5%. "That is partly due to the fact that we see a greater threat of government involvement," he says, "though that remains unclear ... I think there is a cloud over the market, which will remain a cloud and depress prices. But that doesn't mean it's going to rain.
"I don't think it's going to look like the 1980s, 1990s, or 2000s. I think we're in for a new decade. Neither stocks nor bonds look as good as they did a year ago ... but valuations are reasonable," Macey says. "So I think you can be somewhat normally allocated." He adds that investors should create a well-diversified portfolio to guard against the uncertain future (always good advice), noting that commodities are good to have in your portfolio at all times. He favors gaining exposure to commodities broadly rather than through individual stocks like BHP Billiton
John Maynard Keynes famously said, "Markets can remain irrational longer than you can remain solvent." Following this principle, Macey sticks to a seven-year forecast, not a one-year outlook. "Valuations may persist through long periods of time," he says. "So even if we notice whether something is cheap -- or expensive -- that doesn't mean it will become fairly priced in the next 12 months.
"You have much more control over buying into a decent valuation, rather than where you're going to be able to sell. You may not be able to sell at an attractive valuation."
The winning investment combination
There are two investment areas Macey particularly favors, and he notes that he likes them in combination: high-yield bonds and emerging-market stocks. Macey says he favors the highest-rated high-yield bonds because he forecasts 7%-plus returns, which he says is on par with returns in domestic equities, but with half the risk. His time horizon is seven years. "If the economy doesn't do much, you can still get your income, but you won't have much in the way of defaults as we go through the recovery," he says. "We like [this] even if we get some increase in interest rates, which is generally bad for investment-grade bonds."
As for emerging markets, Macey says valuations are still priced competitively with developed markets, but with a slight premium. He says the growth and earnings of emerging markets are double that of developed markets, which validates the premium. "Regardless of the economic scenario, we think this combination offers a very nice risk-reward ratio compared to developed equity markets," he says.
While long-term buy-and-hold failed equity investors over the last decade, Macey says he thinks the strategy will be more effective in the next 10 years. On the flip side, bonds, which had a great last decade, are not expected to produce killer returns in the same time frame going forward, Macey says. He notes that the income to be gotten from bonds is lower because rates have gone down, and there is pricing risk if interest rates go up.
"It's not going to be double digits," he says. "We worry about owning bonds. Over the last 10 years, bonds have done over 6% per year. People think bonds are a good investment -- ‘they've done better than stocks; there's less risk.' Bonds have a place in the portfolio, but we don't want to oversell them."
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Fool contributor Jennifer Schonberger does not own shares of any of the companies mentioned in this article. You can follow her on Twitter. The Fool has established a bear put spread position on Abercrombie & Fitch, and has a disclosure policy.