This article is part of our Rising Star Portfolios series.
The goal of investing is to maximize your capital, which is done by buying assets at prices that ensure (1) your capital is safe, and (2) an adequate return. Historically, the best way to do this has been through equities because they have beat out bonds over time. But as this chart shows, equities can destroy capital, even over long stretches. One such time was the 1960s and 1970s -- when a $10,000 investment at year-end 1961 would have shrunk to $6,600 in 1981 when adjusted for inflation. Even during the period from 1930 to 1950, the S&P 500 returned only 2% annually after inflation and taxes.
Are we in one of those times now? I don't know, but the market doesn't look like a bargain. The cyclically adjusted P/E ratio, popularized by Yale University's Robert Shiller, is a measure that takes the current price of the S&P 500 divided by the average earnings over the past 10 years. It currently sits at a hefty level of 23, even despite strong earnings over the past decade. Shiller himself prefers to wait until this figure drops below 10, and I concur: The market doesn't look particularly compelling.
You can certainly make money on individual stocks in almost all market environments, which is why I'm still scouring the market for value. And I'm not saying the market won't go up from here. What I am suggesting is that you might be at a disadvantage by being fully invested in equities now. The stock market looks expensive, and even more so when you consider the Federal Reserve is propping up housing and other asset classes with newly created money. If growth falters or sentiment turns bearish, investors could shift money out of equities to other assets with more safety or upside potential.
Bonds and cash
Outside of equities, bonds and cash don't get me too excited, either. The paltry yields on offer (3.4% for 10-year Treasuries, less than 5% for investment-grade corporates) don't appear to adequately compensate investors for the risk of rising interest rates. And while cash is liquid and can be deployed in times of crisis or if rates increase, over the longer term, inflation saps its purchasing power. Therefore, just sitting on cash doesn't look that great either.
Rethink your asset allocation
If mainstream markets (equities and bonds) aren't looking attractive, look elsewhere for safe places for your capital. For me, gold fits that bill, as I've argued here and here. I don't want to be in gold forever, but until either other assets become attractive or gold becomes less attractive, that's where I'm turning to protect my capital. Gold can outperform stocks for long stretches of time. From 1961 to 1981, it rose 13-fold (before inflation and taxes), and while this figure isn't exactly comparable with stocks' after-tax real negative return during this time, the point is clear: Sometimes equities are not great investments compared with alternatives.
So far in my Rising Star portfolio, I have allocated $1,000 to a gold miner and almost $5,000 to physical gold via the Sprott Physical Gold Trust (NYSE: PHYS). I consider this prudent because I want to protect my capital, and neither cash, bonds, nor equities (broadly speaking) appear compelling. Just because an activity (buying stocks) has the popular seal of approval doesn't mean it is a good idea. You don't always have to be fully invested in the stock market, and that's OK, because for long stretches it doesn't pay off.
Potential future moves
That doesn't mean, though, that all stocks are terrible. Right now, I have my eye on Rubicon Minerals (NYSE: RBY), a company with a tremendous gold deposit in the very prolific Red Lake, Canada, mining zone that I feel is still undervalued based on peers and recent takeover transactions in the gold space. And I'm still considering defense contractor L-3 Communications (NYSE: LLL), one of my favorite companies because of its high-end electronic products, but especially so now because of its low price. Its earnings yield is a very healthy 10%, which makes it a much better value than the overall stock market right now.
