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Three Great Funds for a Low-Return World

If the S&P 500 is overvalued, these are prudent alternatives.

Last week on Morningstar.com there was an article postulating that the S&P 500 index was "egregiously overvalued." Morningstar stock analyst Curt Morrison, relying heavily on long-term studies of equity markets, came to this conclusion by examining several traditional building blocks of the stock market's historical return--inflation, dividends, and real capital appreciation (earnings). He estimates that earnings growth will have to hit 5.4%, an unusually high number, to justify the index's current level. Right now, Morrison prefers cash to this basket of large-cap stocks.

Morningstar fund analysts like myself hear and read such views pretty frequently. This past summer at Morningstar's annual conference, Bob Rodriguez, manager of  FPA Capital (FPPTX), touted cash over all other assets. Jeremy Grantham of Grantham Mayo Van Otterloo & Co.--who seems to always think everything but timber is overpriced--gleefully predicted doom. We talk to managers almost daily and, especially after a sharp bull rally like the one in 2003, we hear nasty forecasts of low-return environments and a lack of buying opportunities. Yet a lot of us, myself included, continue to hold the  Vanguard 500 (VFINX) index fund.

Stand Your Ground
There are three reasons for holding strong in the face of such pronouncements. First, while a lot of solid thought and research goes into them, they can still be wrong. The formulas could be flawed, price/earning ratios may not fall to historical norms, or the forward-looking expectations (inflation, for instance) could turn out to be off the mark. One need not even figure out how the theory might be wrong, it only matters that it could be. Second, even if you believe the premise, the supposedly prudent response--not owning large-cap stocks--seems extreme, even imprudent. Finally, even if you do get out of stocks (or certain kinds of stocks) at the right time, you also have to get back in at the right time, which is incredibly difficult to do. In other words: I'm not betting my retirement that the naysayers are correct.