Playing Defense as Stock Prices Soar Part 1 of 2
As of this writing, major U.S. stock market indexes are at or near record highs. This bullish run might continue...or it might end with a severe slide. Here are some strategies to consider.
Stay the course Many investors will prefer to keep their current stock market positions. For nearly a century, every stock market reversal has been followed by a recovery. Even the severe shock of late 2008 through early 2009 has led to new peaks, less than a decade later.
What’s more, holding onto stocks and stock funds won’t trigger any tax on capital gains.
Move into cash Investors who are truly nervous about pricey stocks can sell some or all of those holdings, then put the sales proceeds into vehicles that historically have been safe havens, such as bank accounts and money market funds. This would reduce or eliminate the risk of steep losses from a market crash. In both the 2000–2002 and the 2007–2009 bear markets, the S&P 500 Index of large-company stocks fell about 50%. After a loss of that magnitude, investors need a 100% rebound, just to regain their portfolio value.
However, cash equivalents have negligible yields right now, so investors would essentially be treading water in bank accounts and money funds. Timing the market has proven to be extremely difficult, so investors who go to cash risk missing out on future gains as well as possible losses. In addition, investors who sell appreciated equities held in taxable accounts will owe capital gains tax, which could be substantial.
Move into bondsAside from cash, bonds have long been considered a lower risk counterweight to stocks. According to Morningstar’s Ibbotson subsidiary, large-company U.S. stocks have suffered double-digit losses in five different calendar years since the 1970s. In 2008, that loss was 37%.
Long-term government bonds, on the other hand, have had fewer down years. The only year they lost more than 9% was 2009, when a drop of 15% was reported. That 2009 loss, though, came after a 26% gain in 2008, when stocks tanked. Therefore, Treasury bonds can be a useful hedge against stock market losses.
Yields on the 10-year Treasury are currently around 2.6%, so long-term Treasury bond funds may pay about 2%: not great, but more than the payout from cash equivalents. Intermediate-term Treasury funds will have lower yields but also less exposure to stock market volatility.
Investors in high tax states may have another reason to favor Treasury bonds and Treasury funds because the interest from these investments is exempt from state and local income tax. To benefit from the tax break, you must hold Treasuries in a taxable account.
Treasuries certainly can be held in a tax-deferred account such as a 401(k) or an IRA, and many investors do so. However, the state and local income tax break might be lost because withdrawals from tax-favored retirement plans may be fully taxable. (Some states offer tax exemption to distributions from retirement plans, often up to certain amounts.)