Investments that advisers should look at in an overheated market

Editor’s note: This is part of a series looking at how the advice industry is getting ready for the next market correction.

Investing in today’s stock market is a bit like driving 90 miles an hour on a wet highway with bald tires. You may not have an accident, but the odds are higher than if you were, say, abiding the speed limit on a fine, sunny day driving a tank.

The question: What can you invest in now that could minimize the effects of a sharp correction, or even a bear market? Cash and bonds are the traditional buffer, but a certain percentage of most clients’ assets need to be in equities for long-term gains above inflation.

And here’s the problem: U.S. stock prices are high, relative to earnings. The Standard & Poor’s 500 stock index currently sells for 23.8 times earnings, on an as-reported basis. The average since 1988: 18.8 times earnings. The blue-chip index’s dividend yield is 1.96%, vs. an average 3.6% since 1936.

Investing in expensive stocks rarely has a good long-term outcome. Research Affiliates forecasts a 0.6% return, after inflation, for U.S. large-company stocks and 0.3% for U.S. small-company stocks. GMO forecasts a -4.0% average annual return (after inflation) for U.S. large-caps during the next seven years.

Put another way: A January 1, 2000 investment in PowerShares QQQ ETF, which tracks the Nasdaq 100, would have returned an average 2.87% a year, vs. 5% for the Vanguard Total Bond Index ETF.

What’s an adviser to do? If clients have long amounts of time before they need their money — 20 years or more — then dollar-cost-averaging into stocks makes reasonable sense. But older clients might balk at investing in stocks now. What alternatives do you have?

OPTION 1: CASH

“Boring as it may seem, cash is always an option,” said Christine Haviaris, founder, TTR Wealth Partners. “It’s safe, simple, and there when the buying opportunities present themselves. Sometimes the best investment is no investment at all.”

Currently, returns from cash remain miserable. The 100 largest money market funds yield an average 0.66%, according to Money Fund Intelligence, which tracks the funds. The top-performing institutional money funds yield a bit over 1%. On the other hand, a 1% yield looks pretty special compared with a 10% loss or more. And if the Federal Reserve raises interest rates, as expected, money market rates will rise.

OPTION 2: THE MIDDLE GROUND

“The past few years, we’ve been looking at stuff in the middle ground between stocks and bonds,” said Barry Glassman, president of Glassman Wealth Management. “We’ve taken some dollars from bonds and gotten riskier, and taken some from stocks and gotten more conservative.”

Glassman sees high-yield bonds as an alternative to stocks, for example. “It’s not meant to be a bond alternative,” he said. Funds that use relatively high-quality junk — “the cream of the crap,” as Mr. Glassman calls it — are generally less volatile than stocks but generate good returns over time.

But you have to choose the middle ground carefully. Low volatility funds, which invest in the stocks that tend to rise and fall less than the S&P 500, served investors well during this week’s mini-meltdown. But low-volatility stocks have proven so popular that many have PE ratios higher than technology stocks. The average PE ratio of the five largest holdings in PowerShares S&P 500 Low Volatility Portfolio (SPLV), for example, is 25.67.

OPTION 3: INTERNATIONAL

Stock prices are high in the U.S., but the U.S. is not the entire world. German stocks, for example, sell for about 16 times earnings, according to MSCI. “If the timeline is sufficiently long and the client is comfortable going near the current high, I would suggest looking at Europe for some funds,” said Jon L. Ten Haagen, a financial planner at the Ten Haagen Financial Group.

The downside with international stocks is that they tend to slide alongside the U.S. market during a correction. And, while they are cheaper than U.S. stocks, they usually are — they are no longer as cheap as they used to be. GMO estimates a real, inflation-adjusted annual return of -0.7% a year the next seven years. Research Affiliates is a bit more optimistic, with an expected real return of 5.1% a year for the next decade.

A bright spot, however, is emerging markets. Stock markets of lesser-developed nations have languished because investors tend to prefer big, developed markets in times of international turmoil. (They also prefer dollar-denominated investments in times of fiscal crisis.) Currently, emerging markets are cheap, relative to earnings. The MSCI Emerging Markets Index sells for about 15.8 times earnings, for example. And emerging market economies are far less vulnerable to currency depreciation as they were during the 1998 currency crisis.

No one should think that “cheap” means “safe,” warned Matthew J. Bartolini, Head of SPDR Americas Research, in a recent blog post. “Given that EM is the only major region trading below its 10-year average, an investor might be tempted to go “all-in” on this potential value play, but caution remains warranted. EM’s 10-year average figure is low because of the commodity cycle bust, leading to years of negative returns in the region. When gauging value, you never know when an opportunity may be a bit of trap.”

Nevertheless, Mr. Bartolini remains positive on emerging markets because of rebounding growth prospects, particularly in Russia and China. “Years of rising leverage and slowing return on equity have reversed themselves. While still well off their norms, the direction is encouraging.”