Stocks vs. Bonds: What's Better in a Rocky Market?

Interest rates are falling for Treasury bonds, beloved for their safety and steady payout. The stock market is wobbling, and equity prices may fall further if the economy continues to weaken. Since most portfolios contain an element of both asset classes, what's an investor supposed to do now?

It may seem like there's nowhere to turn. Interest rates on 10-year Treasurys, the kind retirees like to sock away in their portfolios, have fallen from 3.84% at the beginning of the year to 2.72% now. The S&P 500 is down 1.11% for the year, but off nearly 11% from its 52-week high.

As a result, investors are clearly confused about what to do. Data from mutual fund researcher Lipper FMI showed a huge outflow of $11.5 billion from equity funds at the beginning of July, but nearly $8 billion was plowed back into stock funds at the end of the month. Meanwhile, bond funds have shown a steady increase, gaining $18 billion in July alone.

Be Sure to Rebalance

Joanna Beswick, portfolio manager at mutual fund giant Fidelity Investments, says investors should resist the temptation to jump out of fixed-income holdings simply because rates are falling. "I'm not sure its wise to change your long-term asset allocation due to short-term market conditions," Beswick says.

But with a long-term plan in place, Beswick says it makes sense to rebalance the portfolio when it gets out of whack due to market fluctuations, as we've experienced recently. Thus, if a portfolio is allocated to 50% stocks and 50% bonds, when the stock market swoons and that balance changes, it makes sense to use fixed-income money to buy equities, she says.

"Those dips in the equity market become a buying opportunity to move the overall plan back to a 50%-50% allocation," Beswick says.

But that doesn't mean investors should be content with the low yields on Treasury bonds. Beswick says the fixed-income portion of a portfolio should be as diversified as the entire portfolio and should include such things as higher-yielding junk bonds and emerging-market debt.

Dividend-Paying Stocks Can Beat Bonds

Lawrence Carrel, author of Dividend Stocks for Dummies, says current market conditions raise the appeal of high-dividend stocks.

"In a volatile environment, where the stock market can go down and bonds are paying extremely low interest, a good place to beat the rate of return on bonds is dividend stocks," Carrel says. "If you can get potential upside in your investment at a yield that is 60% to 100% better than the 10-year Treasury, why wouldn't you take it?"

Carrel suggests stocks like Verizon (VZ), which is yielding 6.29%; utilities like Integrys Energy Group (TEG), which yields 5.68%; or the Utiities Select Spider Fund (XLU), which yields 4.10%.

Carrel likes the fact the even in a declining market, high-dividend stocks have some upside potential. "The thing about dividend stocks, like any income investment, is that even if the market falls, you continue to get income on your investment no matter where the market is going," he says.

Then There's Gold

Brian Kelly, president of Darien, Conn.-based investment adviser Kanundrum Capital, says he has given up on both stocks and bonds for the moment. ""I don't think the risk-reward is there," Kelly says. "Bonds have moved significantly, and you're not getting paid very much for that. Stocks have tremendous headwinds."

The outlook for equities was darkened on Tuesday when the Federal Reserve's interest-rate setting committee issued a downbeat forecast about growth in the country. Economic data coming out of China and Europe also indicated a slowdown is taking shape.

Kelly says he's investing in gold at the moment. He sees two factors supporting gold: the fact that countries around the world, including the U.S., are trying to boost exports by depreciating their money against other currencies. With a fluctuating value, gold tends to rise as the dollar depreciates. Kelly also says central banks are buying gold for the first time in 20 years.

The price of gold, at around $1,216 per ounce, is up about 11% this years, but off its high of $1,271.

Kelly says he's less inclined to look at other precious metals like palladium and platinum because their prices are closely linked to automobile production -- and the car industry may be facing a speed bump because of the slowing economy.