The US stock markets have been on a tear this year, with the S&P 500 up about 30%.

However, world stocks have lagged in performance, and are currently over-sold. Over-sold is a somewhat ill-defined term, and in this context means the price of a stock is selling at less than 1 standard deviation below it’s 50 day moving average. Stocks that are oversold are more likely to undergo mean reversion, and the prices will increase.

Here’s an interesting chart from Bespoke Investments.

As I mentioned in my last post, interest rates are likely to stay low for quite a while.

Investors are starved for yield, and have been bidding up the prices of dividend-paying stocks.

Boring stocks of electric companies and consumer staples (companies that make toothpaste, soap and cereals) usually have limited growth opportunities. Instead of reinvesting their earnings, they tend to pay it out to investors in the form of dividends. As a result, these stocks have slightly higher dividends, and trade at a slight discount to the market (based on their Price/Earnings ratios).

Investors in these sectors are exchanging growth for income.

However, in today’s environment, these stocks are trading at a premium to the average market. Overpaying for income is not how investors make money in the long run.

On the contrary, mature technology companies with massive profit-margins, steady growth prospects, but low dividends, are trading at a discount to the market.

So there is definitely some dislocation in the US markets. But based on continuance of quantitative-easing and the super low interest rates, this trend is likely to continue.

Looking at the foreign markets, we see better valuations in general.

At 14 times forward earnings, European stocks are currently 12% cheaper than their US counterparts, and have 50% higher yields too. However, they’re cheaper than they look on the surface.

Profits at US companies are hitting record highs, whereas in Europe they are at market cycle lows, and are on the upswing. As profits expand, so will the stock price and the yield.

The emerging markets are even cheaper. At less than 12 times forward earnings, they’re more than 25% cheaper than US stocks.

While emerging markets have been the sore spot in investor portfolios, significantly underperforming US stocks for the past three years, they are currently so cheap they warrant inclusion. Here’s an excellent paper by Vanguard on this topic.

But investors can do better than just buying cheaply here.

According to research by Jim O’ Shaughnessy, author of What Works On Wall Street, tilting towards undervalued, dividend-paying stocks in emerging markets beats the category by 10.6% per year over the long term.

As I’ve said before, maintaining a globally diversified portfolio is the key to long term wealth.

And global stocks definitely looks primed to perform well in the coming year.

But be sure to see our disclaimer.

The US stock market returns has certainly had a banner year, so far.

We’ve certainly had a lot to worry about such as the fiscal-cliff tug-of war, various European government and political scares, capital flight from emerging markets, tapering of the Federal Reserve bond-buying program, and the US Government shutdown.

And yet the market has maintained its solid march upwards, hitting new highs last week.

But while the stock market has been climbing higher, people looking for income to live on are stuck.

Right now, it’s the toughest environment for generating income in over 100 years.

According to data from Global Financial Data, a portfolio consisting of 60% stocks and 40% bonds has historically generated an average 4.4% yield. Right now you’re looking at an all-time low of less than 2.0%.

Janet Yellen, the new Federal Reserve Chairman, said she’s going to maintain this low interest rate environment.

An astute observer might think that low interest rates seem like a punishment for savers and especially for retirees. And they’d be right.

When faced with a similar question, Yellen said “we have to consider the role of people who have significant savings and their responsibility in society, that it really is selfish to be hoarding it and that we need to create incentives through government for people to spend their savings,  because that’s exactly what we need in order to rejuvenate the economy.”

Yes, the new Federal Reserve Chairman thinks people who save their money are selfish. And they need to spend their savings to help boost the economy.

Not only that, at a recent Senate Banking Committee hearing, she said if she could figure out how, she’d even introduce negative interest rates. This means you’d have to pay the bank to keep your money in a savings account, while those taking out a loan would be paid interest by the bank.

 You might think this is an incredibly stupid idea. I do.

Regardless of whether she’s right or wrong, the truth is that interest rates are going to stay close to zero for a very long time.

The Federal Reserve is going to maintain its loose monetary policy, which means the bond buying program is going to stay strong.  This bond buying injects money in to the economy, and it’s going to end up in stocks and real estate, and continue to push the prices higher.

Meanwhile, the US stock market has gone more than 18 months without a 10% correction. While we are not in bubble territory, as a whole, they are fairly valued.

But that doesn’t mean that prices are going to stop rising here.

Most likely, they’re going to continue their rise for quite a while. As previously explained, rising interest rates won’t stop this increase either.

As always, the best course is to keep calm and stay invested!

Based on my prior experience buying nearly two dozen homes across the country, I’m frequently asked for advice on buying real estate.

The attraction to real estate investing is easy to understand. Although real estate can’t be expected appreciate more than the rate of inflation (unless you have the vision to buy in to an area where demand is about to take off, such as Southern California circa 1960), the leverage and tax breaks make it look promising.

And the recent downturn, coupled with the ultra-low mortgage rates, have made real estate a hot investment in the past 12 months.

In Los Angeles, the median home price has jumped an eye-popping 23% in the past year, from $422,000 to $520,000.

So what does the future hold?

While it’s always hard to predict anything, it definitely looks like housing is getting overvalued in some areas.

Looking at the ratio of Median Home Prices/Median Household Incomes, we can see that California is getting expensive on a historical basis.

According to John Burns Real Estate Consulting, it’s 50% higher than the historical average in Los Angles, Orange County, San Diego and San Francisco.

[Click to enlarge]

That’s not to say you can’t find a good bargain in this market. But they’re becoming a lot harder to find.

Unless you’re buying a house to live in yourself, it might be better to look in Florida, Arizona or  Nevada to get a better deal.

Wow, it’s been five years already. Five years ago it looked like the entire financial industry was about to collapse.

Major financial institutions, global banks, and hedge funds of assorted varieties went bankrupt. Companies like Bear Sterns, Washington Mutual and Lehman Brothers are no longer around. They either went out of business, or were acquired by other firms with assistance from the Federal Reserve.

The common thread was excessive leverage, and a lack of understanding of the underlying investments.

The resulting economic meltdown caused the biggest recession since the Great Depression, and a 43% decline in the S&P 500 (a broad index of the US stock market). Between March 2008 and February 2009, many investor portfolios that weren’t properly diversified across different asset classes saw declines of 50% or more.

Since then, the US economy has been slowly grinding forward. It no longer seems like we’re on the verge of economic collapse, but we’re not in a booming environment either.

Unemployment is still high (Forbes has a good article on why unemployment is higher than you think). The median household income, adjusted for inflation and seasonality, is 7% lower than it was in 2007.

But the US stock market has been on a tear and has achieved new highs several times this year. In the past 3 years, the S&P 500 is up 55%.

Some investors believe that the recent rise in stocks in not reflective of the current economic situation.

If you add the fear of rising interest rates to this mix, you wouldn’t be surprised if they though a sharp decline in the stock market is imminent.

And in fact, the stock market has drifted lower over the past weeks – rare for this year, although not uncommon for the month of August.

One question I’m frequently asked is whether it’s a good time to invest or not? I get asked this question, regardless whether the stock market is up or down, after all,  there’s always something to worry about.

But this time, it’s prefaced with one scenario we haven’t seen for an entire generation – the real threat of rising interest rates.

 “Stocks are at an all-time high, and interest rates are definitely going higher. The stock market is going to collapse. I’m scared about my future!”

What Happens To Stocks When Interest Rates Rise?

While history doesn’t always repeat itself, it often rhymes with the past. So let’s look back at the last time we were in a similar situation to see what happened to stocks.

We have to look back a really long time –  nearly 60 years.

Back in 1950 the Federal Reserve had manipulated interest rates to keep them artificially low and bottomed around 2.3% (not too far from where they are this time around).

But in 1955, the interest rates reversed their trend and started moving upwards. It wasn’t until 1969 (nearly 15 years) that interest rates hit 6%.

Between January 1^st 1995 and December 31^st 1969, the stock market had a compound annual return of 10.02%. (Note, compound annual return is the geometric return, and not the somewhat misleading simple average or arithmetic return which was 11.16%)

The last time interest rates went from 2.7% to 6%, the stock market went up four-fold!

Were stocks much cheaper in 1955 than they are today? Not really.

In 1954, the stock market rose 56%, and by 1955 stocks were trading a Price/Earnings multiple of 13. We’re currently trading at a P/E of 16, and if you believe 2014 estimates then we’re only at a P/E of 14.

And if you’re investing in a globally diversified portfolio, you’ll be buying international as well as emerging market stocks – all of which are currently cheaper than they’ve been in the past few years.

A lot of my favorite large-cap dividend-paying international stocks are trading at P/E multiples between 9 and 12.

Prudent investors buy stocks when the P/E is historically low.

So while no one can reliably predict the future, I expect the future long-term returns of a well-balanced and globally diversified portfolio to be quite good. We might see some ups and downs, but we’re still a long way away from being ridiculously over-valued.

Sticking to your predetermined investment plan regardless of short-term events is the best way of reaching your long-term goals. As always, keep calm and carry on!

Sometimes the direction of the market can change with just a few words.

That was certainly the case on June 19^th, when the Federal Reserve Chairman Ben Bernanke mentioned the possible end of QE3 in 2014 and the prospect of reducing the central bank’s monthly bond purchases later this year.

Almost immediately, nearly all global asset classes started to sell off. Including the ones that are supposed to be uncorrelated.

Choosing uncorrelated asset classes is the cornerstone for a well-diversified portfolio. History shows that over the long term, this helps smoothen investment returns, which are usually quite volatile.

But once in a while, everything correlates to the downside.

The week after June 19^th was one of those times. Stocks, bonds, commodities – everything got hit pretty hard.

Investors often get caught up in the fluctuations of the market. They panic and sell when prices drop, then fall victim to “irrational exuberance” and buy when prices soar.

This is a sure way to lose money.

And research from Dalbar shows us how much this behavior costs.

During the 20 year period ending in 2012, the S&P 500 index returned an average annual 8.21%. But the average person who invested in stock mutual funds earned only 4.25% – trailing the stock market by almost 4% a year.

While part of this loss can be attributed to high mutual fund fees, most of it is due to investors jumping in out of the market at “bad” times. For investors in bond funds, the returns are even worse.

The best course of action for investors is to accept that markets cannot be timed, and build the expectation of unexpected events (also called black swans) occurring from time to time.

Investors don’t earn returns smoothly over time. Instead, they earn them largely as a result of unpredictably bursts and crashes. Given that much of the action happens on such a small number of days, the odds of successfully predicting the days to be in and out of the markets is close to zero. The real danger is not being there when the big moves occur.

Predicting market tops to sell and bottoms to buy back in is an impossible feat. It’s entertaining, but not a good way to make money.

The only way to “beat the market” is by keeping calm and using these pullbacks as an opportunity to rebalance your portfolio to your predetermined asset allocation.

In theory this can be tough to accomplish.

Especially when so-called “safe” investments like bonds and bond funds declined more than 5% in just a few weeks.

Bonds are one of the beneficiaries of the Fed’s Quantitative Easing or bond buying program. The Fed’s consistent buying keeps the demand strong, the prices high and the yields low. Withdrawal of this support would cause demand to decline and interest rates to spike.

And if interest rates (and yields) go up, bond prices will fall in proportion to the duration.

Duration is the amount a bond (or bond fund) would decline, if interest rates rose 1%. For a bond fund with a duration of 5 years, a 1% increase should correspond to a 5% decline in the price.

Last month, the yield on the 10 year treasury rose about 1%.

However, a lot of bond funds lost more than the anticipated amount you would expect. In the case of certain closed-end funds, the decline was significantly more. In some cases, it was closer to 8 or 9%.

This is like selling a dollar for 92 cents! And it leads me to believe that the selling is probably over-done in the short term.

In the long term, you don’t have much to worry about either. As your interest from bonds gets reinvested, it will buy bonds with a higher interest rate, generating a higher future income.

So, as hard as it sounds, stick to your investment allocation.

Hopefully your bond exposure is limited to funds to short durations, limiting your risk to rising interest-rate.

Otherwise, there’s not too much to be worried about. As I mentioned in May, the summer stock swoon was expected. Just keep calm and carrying investing.

Despite expecting a pullback in the market, it was up another 2.3% in April.

In fact, the market has gone on to hit a record high last Friday. The S&P500 (a representative index of the US stock market) has seen amazing gains this year, up more than 10%.

The stock market has been quite resilient this year.  It shook off the recent Boston bombings as well as the sudden drop in gold prices.

But this sort of performance is usually followed by a pull back, as the market digests its gains. And because of the time of year, that’s what everyone expects.

Between the summer months of May through September, there’s usually a lull in the market. People  are on vacation and summer stock market rallies are rare. In fact, the market often sees a summer swoon, which has resulted in the “Sell in May, and go away” theory.

One concerned client wondered if that was a good strategy to follow, especially considering this years excellent performance. We addressed that very valid concern in one this month’s articles.

While summer is bad for stocks, it’s usually very good for real estate. And everyone seems quite bullish on it right now.

Over the past few months, I’ve come across a lot of news about how real estate has turned a corner and how prices are up in many metros across the country.

In February, the average home price increased 10.2%. This marks the 12^th month of consistent gains. Stocks like Home Depot are at all-time highs and home builders are at the highest level in five years. The latest edition of Bloomberg BusinessWeek had an article about people are lining up to bid on houses just like in 2007.

Phoenix is up 23% in the past year, San Francisco is up 19% and Las Vegas is up 17.6%.

Yes, the economy is recovering, but is a 20%+ increase in home prices sustainable, or even justified?

In my opinion, the spike in home prices is driven more by an artificial constraining of supply than a real growth in demand.

Private equity firms like Black Rock and Colony Capital have bought over $5 billion worth of houses in the past six months for the sole purpose of renting them out.

As the number of rentals has increased, the rents have dropped and the vacancy rates have skyrocketed.

Rents in Phoenix are down 10% from last year. In San Francisco, it’s 29% cheaper to rent than to own a property. The vacancy rates for Colony Capital’s rentals are reportedly 40%. Since their borrowing costs are so low, and their pockets are so deep, they can afford to keep a house vacant for five months. Individual investors might not be so lucky.

The valuation of any investment is determined from the revenue it generates. For real estate, the value comes from the rental income. If the rental income drops, the property becomes less valuable and the price should drop, not increase.

If the economy is growing at a fast clip and people’s incomes are growing faster than inflation, then these numbers don’t look too bad.

However, compared to 2007, more people are unemployed and the median household income is nearly 7.3% lower than it was in December 2007.

Additionally, any increase in interest rates will put additional pressure on home buyers, since the mortgage carrying cost will be higher.

Until these factors are mitigated, I’d be skeptical of any housing recovery that’s driven by private equity investors.

As an owner of investment real estate myself, I have first-hand experience of all the issues that can arise with rental property.

This past November, I spent 7% of the value of a property on repairs after a tenant trashed the place and moved out. Coupled with the loss of two months rental income, my net income for the whole year was less than 1 month’s rent. Not exactly a hassle-free investment.

This doesn’t mean you shouldn’t buy real estate. There are significant tax benefits for owning your own home, and you always need a place to live.

But if you’re in the market for a rental property, you should be careful.

Unless you’re personally managing the property, your actual returns will vary. As an investment asset class, the amount of personal attention required often offsets the attractiveness of returns. Coupled with the illiquid nature of it, sometimes it’s just not worth it.

If you’re a busy person, you’re probably better off getting exposure to real estate through Real Estate Investment Trusts (REITs). REITs are liquid, publicly traded companies which give you access to various commercial, residential, industrial and health-care properties. They pass on nearly all of the income, offering decent yields, without any of the maintenance hassle.

However, if you’re keen on buying actual rental properties, I advise you to make sure you run the numbers thoroughly, and keep a little bit of cash in reserves for unexpected expenses.

For our existing clients, I’m happy to use my extensive real estate experience and knowledge to advise them on any real estate deals they might be looking at.

But as I said earlier, unless you’re buying your primary residence, I’d be wary of buying real estate as an investment just yet.

Typically, during the summer six-months period of May through October, the U.S. stock market under performs the remaining six-month period of November through April.

According to the Stock Trader’s Almanac, since 1950, the Down Jones Industrial Average has had an average return of only 0.3% during the May-October period, compared with an average gain of 7.5% during the November-April period.

Every year around this time, the popular press gets all excited will bring up the issue of whether you should “sell in May and go away”. They always have some justification for making a forecast and they like to pretend they can predict the future.

And every year, I get asked by friends and investors if there’s any truth to this adage.

Especially this year.

This year the S&P 500, a good representation of the US stock market, is up a whopping 10.5% year-till-date (as of April 29th).

Considering that the market was up strongly in the past couple of years and then gave back all the returns in May, should we at least consider selling in May and going away?

No, we shouldn’t. While the average return has been 0.3%, it might very well be 7%.

You shouldn’t try to time the market.

No one can reliably or consistently predict when the market will top, and conversely, when it will bottom. If they could, they surely wouldn’t be sharing their secrets with the press, or bother managing your money.

Secondly, if you’re invested in a well-diversified portfolio, you don’t even need to worry about timing the market.

A well-diversified portfolio has allocations to many different sectors — U.S. stocks, international stocks, emerging market stocks, commodities, real estate and bonds, just to new a few.

While the S&P 500 may have had a terrific year so far, the rest of the market has been lagging.

Bonds and international stocks are flat, emerging market stocks have lost a few percent, and commodities have seen a major decline.

So while the largest stocks in the US have had a great year, the other sectors have not.

If you’re using a financial advisor, you’re probably in a well-diversified portfolio with specific allocations to various sectors.

This portfolio was carefully chosen for your unique situation by considering your personal finances, your risk tolerance, and investment objectives.

If your advisor is like me, he spent a lot of time and effort constructing a custom portfolio that’s forward looking, and attempted to match the market (or a benchmark return) with less volatility. (Being able to match a benchmark return with less volatility is called improving the Sharpe Ratio of a portfolio. The Sharpe Ratio is the only way to do a true apples-to-apples comparison of two portfolios, but that’s a topic worthy of a separate discussion).

Hopefully, he’s not just creating a portfolio of last year’s winners that is rebalanced once a year in to the current batch of “last year’s winners”. Performance chasing never works and only serves to generate fees for certain types of brokers.

Regardless, he would regularly rebalance your portfolio to bring it back in line with your target allocations.

What is rebalancing? It’s where you sell some of your winners, and use the proceeds to buy some of the losers. Yes, it sounds counter-intuitive, and no one likes to sell a winner and buy a loser. But it’s been academically proven to increase returns while reducing the volatility of the portfolio.

Nothing goes up forever. Sooner or later, your winners will fall. And your losers will outperform the market.

Take Apple (AAPL) for instance. It’s down 20% this year. Meanwhile, Microsoft (MSFT), which has gone nowhere for a decade, is suddenly up 23% in the same time frame.

It’s impossible to determine which stock, or sector, is going to outperform in the short-term.

Supposing you had a 35% allocation to US large-cap stocks in your portfolio. The 10.5% rise would mean nearly 39% of portfolio was now in that sector. If you sold just 4% and reallocated to the sectors that had underperformed, you would effectively be selling high and buying low.

This is one of the few true secrets to making money in the stock market. Yes, it’s that simple.  You use a rebalancing system to sell high and buy low.

A study by Crestmont Research shows that infrequent rebalancing in a bull market adds 0.3% return. However, during a bear market, frequent rebalancing adds 1.3%. Yale Endowment stated that regular rebalancing added 1.6% return in 2003.

Let’s say over the next six months, the largest U.S. stocks did in fact decline 5%. Meanwhile the other sectors in your portfolio appreciated beyond their target allocation. In six months time, you’d again rebalance and sell some of the winners to buy back the same sector you sold in April – the largest U.S. stocks. Just in time for the November – April run up in prices.

On the other hand, if the largest U.S. stocks didn’t decline, but instead continued their upward ascent, the 35% of your portfolio that was allocated to them would benefit from that exposure.

In a way, you get the best of both outcomes without choosing a preference.

This is the strategy we follow for our clients, as well as our personal portfolios. Of course, our strategy is slightly more complicated. We use a proprietary system that considers percentage threshold, time and standard deviation in rebalancing.

It may be a simplistic idea, but it’s academically proven to work over the long term. In fact, it’s the same method followed by large billion-dollar endowments.

The two most common complaints to rebalancing are trading costs and taxes.  We’ve managed to eliminate the excess trading costs by using a brokerage company that charges our clients a flat monthly fee, regardless of number of trades. And since for a majority of people, the majority of their investments are held in retirement accounts, taxes aren’t an issue either. We also use tax-loss harvesting to minimize the effects of taxes in non-retirement accounts.

The only real drawback to rebalancing a well-diversified portfolio is that it might underperform in an extended bull market. But, as any investor who has been investing for several years knows, nothing goes up forever. If you manage risk well, you don’t have to stretch for returns.

Last week gold prices dropped 15% in two days. This was the largest drop in 30 years, and created widespread panic on Wall Street.

Hedge funds and traders who were betting on the rise of gold prices via futures and the gold ETF found themselves having to unwind their positions in a hurry. The ensuing panic selling probably fueled the downward decline.

All over the news, the pundits came out saying that the bull market in gold is now over.

Several investors called in, quite concerned about what was happening and what they were reading in the media. After all, a couple of our portfolios hold a small allocation to gold.

So, should you panic about the collapse of gold?

First of all, consider why do we own gold?

I like to think of gold as a form of insurance. As one of my friends’ likes to call it, a chaos hedge – for when things get really bad. 

Historically, gold has provides a long term hedge against  monetary mismanagement. That’s one of the reasons why it’s price has been increasing for 12 years. As the Federal Reserve and the European Central Banks keep printing more money to solve their countries financial problems, gold prices have risen every single year for a dozen years.

You can’t expect an asset class to go up without taking a break now and then.

Besides, as confidence in the economy improves and the stock market keeps hitting new all-time highs, gold prices can and will take a backseat.

So if we know that gold prices are going to lag stock returns, should we  sell it in favor of stocks?

No.

Mainly because no one can predict the future.

Also, academic research has shown that even if the expected real return of an asset class is zero, when added to a diversified portfolio and coupled with regular rebalancing, it will improve the overall returns and reduce volatility. In plain English, this means that even if the long-term price of an asset is unlikely to beat inflation, it can increase your returns and reduce the sharp declines in your portfolio.

Besides, the panic selling seems to be driven by the futures market – the domain of speculators and Wall-street traders. There have been reports from Dubai, India, China and Bangkok about a shortage for physical gold. People who actually buy gold are jumping over themselves to use this pull-back to buy more.

In the short-term prices may fluctuate wildly, but unless you’re short-term speculator on margin, you should be fine.

So, as usual, my recommendation is to keep calm. There’s always something to worry about in the investment world. But unless, you’re in Cypress and all your wealth is in the bank, you shouldn’t have anything to worry about.

The Cypress reference is about a retiree who worked for 35 years in Australia and moved back to Cypress with $1 million that he deposited in the bank. When the Cypress bank folded last month, he lost nearly all his life’s savings. Maybe this is why people are still buying physical gold?