After nine years of strong gains, the U.S. stock market has slowed this year, with the S&P 500 index up just over 5 percent since the end of December and a tad below its late-January peak, while rising interest rates threaten bonds. What are investors to do — buy, sell or stay the course?
The question is there all the time but can seem especially sharp in a sideways market, when the impulse to play it safe and finally realize gains through sales is complicated by the fear of loss if markets tumble, or of missing out if they roar back to life.
“I think that the current market is all about the interplay between earnings and interest rates,” says Robert R. Johnson, principal at the Fed Policy Investment Research Group in Charlottesville, Virginia. “We are in a rising interest rate environment, and research shows that during a rising-rate environment, large-cap stocks perform markedly worse than in a falling interest rate environment.”
Rising rates also undermine bond prices as investors would rather have newer bonds that pay more, Johnson adds. That means both major asset classes are risky today, even if the economy and corporate earnings are strong.
[See: 7 Bond Funds to Buy as Rates Rise.]
Experts typically say it’s unwise to do anything in a panic, and that a sound long-term plan set up years ago should have assumed there would be periods like this. After all, most asset allocation systems rely on past market patterns that include up, down and sideways markets. If so, sticking with the plan would usually make the most sense.
But that may worry an investor who faces an unexpected financial need, a changed life situation like a divorce, new baby or retirement, or who questions whether the master plan really did account for periods like this well enough.
Financial advisors and other pros suggest a kind of financial gut check in times like these focusing on some key issues and strategies:
Writing covered calls. In options trading, a call gives its owner the right to buy a block of stock for a given strike price over a set period. The seller, or writer, of the call charges a premium that’s generally a fraction of the current stock price. A covered rather than naked call means the writer already owns the shares the call buyer can purchase if the option is exercised.
Johnson recommends that ordinary investors boost their income by repeatedly writing “out of the money” covered calls.
“For example, let’s say you own Phillips 66 (ticker: PSX) and believe that it’s approaching full valuation,” he says. “It is currently selling for around $122 per share. You could sell the $130 January call options and collect a premium of $3 per share.”
That’s $300 for the 100 shares in a standard options contract.
If the stock goes above $130 you would likely have to sell for $130. If not, you would keep the shares plus the $3-per-share premium. An investor who did this on the same block of stock several times a year could significantly increase income and build a cushion to soften the blow if the stock tumbled.
In a sideways market it’s less likely the options would be exercised — a plus for one who wants to enjoy further gains if the market perks up.
Re-examine allocations. Research has shown performance depends more on the way a portfolio is divided among various types of stocks and bonds than on the individual investments chosen. While experts say it’s generally best to stick with the mix most likely to work best over a given time horizon, like the years to retirement, allocations can be adjusted modestly when new cash is invested or freed up from sales. Some sectors are more promising than others during times like today’s, Johnson says.
[See: 14 Investing Books for National Book Lovers Day.]
“The best performing sectors when rates are rising are energy, utilities, consumer goods and food,” Johnson says. “People need to eat, put gas in their cars, brush their teeth and heat their homes regardless of the direction of interest rates. The worst performing sectors are autos, durable goods, retail and apparel.”
Take cash carefully. The investor who needs cash from the portfolio should have a disciplined system for choosing the source, says Christopher Kimball, president of CK Financial Services in Lakewood, Washington.
“The strategy is to structure the distribution so the money comes from the position which has grown since the last distribution was taken,” he says. “If none of the positions are up, then either take money from the cash reserves or from the position which has gone down the least.”
Trimming the holdings that have gone up or fallen the least can help to maintain the asset allocation in the plan.
Look further afield. A jittery investor such as one seeking more income might look beyond the standard lineup of stocks and bonds, says Jeffrey Feinstein, vice president with Lenox Advisors in New York City.
“Don’t try to get too fancy by selling in and out of positions or overtrading,” he says. “You’ll be hit with taxes, sales charges, transaction fees, etc., and it’s never a good idea when the market is fairly flat.”
That said, Feinstein says changes may be warranted in some situations.
“If you’re in the position of near retirement, or need the income, consider uncorrelated assets such as real estate investment trusts or insurance products that typically have income options and guarantees, that the [stock and bond] market does not have,” he says.
REITs own property or mortgage securities and often offer yield in the high single or low double digits. Insurance products like annuities guarantee an annual income in exchange for a large payment up front.
Be tax smart. The investor who concludes the portfolio allocations are no longer appropriate can avoid immediate tax on gains by confining those sales to tax-favored accounts like individual retirement accounts and 401(k)s. That way you can get out of car makers and into utilities without a nasty bill come next April.
However, an investor can reduce the tax bill by selling any losers held in taxable accounts, says Tenpao Lee, professor of economics at Niagara University in Lewiston, New York. Those losses can offset taxable gains from other sales and reduce ordinary taxable income by up to $3,000 a year.
“When making adjustments, we need to [use] tax-deferred accounts first [to avoid tax on gains] and take losses in taxable accounts, especially in a near retirement status,” Lee says “If you are already retired, you are in a lower tax bracket, you should have more room to make adjustments and ignore tax consequences.”
[See: 9 Ways to Get Income from REITs.]
Be wary, not scary. “History has also shown us that even though the economy is strong, a market correction can occur at any stage,” Feinstein says. “It’s important to be mindful of long-term goals. Do not sell in a panic.”
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How Should Investors React to the Sideways Market? originally appeared on usnews.com
