With the U.S. stock market near its all-time high, where do you go for decent income investments?
Emerging markets are less overvalued, but solid income investments among emerging markets companies are fairly rare, and withholding tax bedevils their yields.
So the best strategy for an income investor today could very well be the “Sleeping Beauty” strategy – put your money to bed for a few years, and wake it up when there are better opportunities in the markets.
But there’s a strategy behind this approach. Here are some suggestions on how to execute it…
Avoid These Poisoned Apples
The Sleeping Beauty strategy won’t make you rich overnight. That’s because, ideally, you shouldn’t be in shares – your objective is to buy better income investments following a bear market.
And the likelihood of a bear market within the next 18 to 24 months increased last week with the revelation that first-quarter gross domestic product (GDP) grew only 0.5%.
In addition, current U.S. share valuations are above average, in terms of price-to-earnings (P/E) ratios, while earnings are close to record highs as a percentage of GDP.
You can’t sustain above-average P/E ratios or record earnings in an economy where GDP is growing below 2% and productivity is growing well below 1% annually.
Following the Sleeping Beauty strategy, you also shouldn’t be in long-term bonds or high-risk corporate bonds.
Long-term bonds don’t yield much today, and they decline in price when yields rise, giving you a capital loss when you sell them to redeploy the money.
Risky bonds become even riskier in a recession, giving you even larger capital losses.
Nor should you be in real estate. Low interest rates have propped up real estate prices… but a rise in rates, coupled with a recession, would ding them.
Furthermore, rental incomes fall off a cliff in a recession, as rental properties go empty and incur expenses. You also can’t sell real estate in a recession.
Finally, and more controversially, you shouldn’t have more than a modest portion of your investments in cash.
Cash gives you almost no income currently (although it’s better than it was).
But the biggest problem with cash is the temptation to invest it too early. If the stock market drops 10%, pundits all over the media will be blithering on about how stocks are now “real bargains,” and there are “unparalleled investment opportunities.”
If you’re holding cash, you’ll be tempted to believe this nonsense and redeploy your money well before you should.
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Think of what you would’ve lost redeploying money at the beginning of 2008, when the market was already down 10% from its peak, but had another 50%-plus to go.
You need funds for emergencies, and perhaps 5% in cash just in case a truly unexpected redeployment opportunity arises – but no more.
How to Execute the Sleeping Beauty Strategy
The best way to execute the Sleeping Beauty strategy is to invest in equal amounts of high-quality bonds of one-, two-, three-, four-, and five-year maturities. This strategy is called “laddering.”
It’s typically executed in government bonds, but you can also use high-quality corporate bonds if you want a higher yield. But don’t invest in anything rated below AA- or Aa3.
As each tranche matures, decide whether to invest the money in solid dividend stocks, because yields have now risen to a level that gives you a decent income, or in another tranche of five-year bonds.
Your principal is preserved by holding each tranche to maturity. Although, if the market is at a truly exciting level – say the Dow is at 4,000 and 10% dividend yields abound – you could sell the tranches that are still outstanding for a modest loss compared to the gain of buying stocks at such low prices.
That’s why it’s called the Sleeping Beauty strategy. Essentially, you “wake up” 20% of your money each year for the next five years to see if the handsome prince of decent income investments has arrived.
If there’s no prince, simply put your money back to sleep for another five years.
But if a prince has brought income opportunities beyond your wildest dreams, wake up the other four-fifths of your money and suffer the modest loss of waking it up early.
Most of the time, you’ll only invest one-fifth, just in case next year brings a better prince.
In today’s market, you’ll get a running yield of 0.94% on a ladder of one- through five-year Treasury bonds. If you need 4% per annum to live comfortably, you’ll have to dip into 3.06% of your capital in the first year and each year your money is asleep.
But even after five years, you’ll have absorbed only 15.3% of your capital. And if the other 85% is invested in stocks at average prices – 30% below today’s prices – you’ll be well ahead of the game.
For us humans, sleeping for several years ages us and shortens our waking lives, which is why we don’t do it.
But our money doesn’t age. So if the market is close to record levels, a Sleeping Beauty strategy can make it worth much more in terms of the stocks it will buy.