Stocks and higher-yielding "junk" bonds have surged so much in recent months that bargains are getting difficult to find.
At the same time, safer investments such as Treasury bonds and high-grade corporate issues have meager yields.
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Faced with this dilemma, investors should plan for lower returns ahead. But they also can look to certain pockets of value within the stock market, as well as some junk-bond funds with a history of beating their peers without taking on too much risk.
Investors have turned sweeter on risky assets in part because of a smattering of good economic news. The U.S. economy grew by 3% in the fourth quarter, faster than originally reported, the government said Wednesday. Jobless claims are near a four-year low. The inventory of homes listed for sale has shrunk.
But investors also have been nudged toward risk by the Federal Reserve, which has been buying Treasury bonds to drive down interest rates. On Jan. 25, the Fed gave an unusually long look ahead, saying the Fed funds rate is likely to remain "exceptionally low" at least through 2014.
That means bond yields, which move in the opposite direction of price, aren't likely to soar soon. The 10-year Treasury recently yielded 2%, versus an average of 6.2% since 1953. Yields on high-grade corporate bonds are likewise near record lows. Procter & Gamble (PG) last month issued 10-year bonds with a 2.3% coupon. H.J. Heinz (HNZ) this past week sold five-year bonds that pay just 1.5%. Most money-market mutual funds pay less than 0.25%.
Meanwhile, the inflation rate was 2.9% over the year through January. The upshot: investors are looking at paltry, or even negative, returns in safe investments like these, after adjusting for inflation.
The problem is that risky assets have run up sharply. The Standard & Poor's 500-stock index has returned 9.7% this year through Thursday close to what it has historically returned, on average, in an entire year. The index has roughly doubled from its financial-crisis low three years ago.
One way to tell whether stocks are cheap or expensive is to compare prices with company earnings. The S&P 500 closed Thursday at 15.8 times reported earnings for the past four quarters. Its historical average is 15.5 times earnings, according to data provided by Yale University economist Robert Shiller.
Stocks are worth a premium during periods when earnings are poised to grow quickly, all else held equal. But Wall Street's earnings forecasts have been steadily falling over the past six months, according to Howard Silverblatt, senior index analyst at S&P.
This quarter's earnings are now expected to be just 6% larger than those from the same quarter a year ago, when the growth rate was 16%. (Please see "Playing the Profit Wave," Page B9.)
So while stocks don't seem wildly overpriced, they do seemed priced for mediocre returns.
But there are good deals to be found within some sectors. Among the 10 economic sectors represented in the S&P 500, financials are the least expensive, discounted about 15% to the broad index, based on trailing earnings. And earnings for the group are projected to grow just as fast as those for the index this quarter.
On the other hand, technology is priced on par with the broader market, but its earnings are expected to grow faster this quarter, by 10%.
Investors can get broad exposure to these sectors with modest expenses via exchange-traded funds like iShares Dow Jones U.S. Financial Sector Index (IYF) and Technology Select Sector SPDR. But each sector has some parts that are more attractive than others, says Mitch Rubin, a managing partner at RiverPark Advisors, an asset manager overseeing $350 million.
Among financials, Mr. Rubin dislikes companies that are in the primary business of lending money, because yields are so low. That rules out most banks. But he likes Blackstone Group (BX), because as a global investment company it has exposure to rising wealth. The company is structured as a limited partnership and must pay out the bulk of its profit in dividends. It currently yields more than 5%.
In technology, Mr. Rubin shuns old-line computer makers that are struggling to hold on to market share. He favors eBay (EBAY) and Google (GOOG) because both have more cash than debt, are priced in line with the market and are growing their profits by double-digit percentages.
High-yield bond prices have soared, too, as yields have plunged. The Bank of America Merrill Lynch U.S. High Yield Master II index recently yielded just over 7%, down from about 20% during the financial crisis.
Investors should expect total returns of closer to 4% a year on these bonds, according to a recent analysis by MFS Investment Management in Boston. That's because junk bonds tend to lose around two percentage points of their return to defaults on average. Also, the average junk bond is now selling at a premium to what investors will receive at maturity. That, along with trading costs, could shave another percentage point or so from returns.
It is possible to shop for bargains within the junk-bond universe, but that is best left to experienced mutual-fund managers, says Eric Jacobson, head of fixed-income research at Morningstar (MORN) .
Some funds have a better record than others of delivering solid returns without excessive risk. Mr. Jacobson likes Vanguard High-Yield Corporate and Fidelity High Income, both of which have relatively low fees.
The Vanguard fund costs 0.25% a year and has a yield of 5.5%. It returned 6.2% a year over the past 15 years, versus an average for high-yield funds of 5.3%, according to Morningstar data. The Fidelity fund costs 0.75% a year, yields 5.8% and has also returned 6.2% a year over 15 years.
A final thought for savers looking for a place to park cash: Now might be a relatively good time to spend some of it. Any purchase carries an opportunity cost in the form of the return that could have been earned if the money were invested. That means spending looks more attractive now than it did three years ago.
That isn't a reason to squander, of course. But the new roof and the family trip to the Rockies that got put off during the market crash are starting to look like better deals relative to what is on offer in the stock and bond markets.
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