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High-Octane Fuel for Stocks

Dick Young — Fri, 23 Jul 2010 19:11:41 +0000

Since I graduated from Shaker Heights High School in 1959, the most important driver of long-term stock market returns has been the direction of interest rates. Bonds compete with stocks in investors’ portfolios. When interest rates rise, the prospective return on bonds goes up. In order for stocks to remain competitive with bonds, their prospective returns must also rise. Prospective stock returns rise when prices and valuations fall. Think of the dividend yield on a stock. If you own a $100 stock that pays a $4 annual dividend, you are looking at a 4% yield. If the price of that stock falls to $80, the dividend yield would increase to 5%. All else equal, when the same stock offers a higher yield, you obviously earn a higher return.

So then, we have established that rising interest rates detract from stock market returns, but what happens to stock prices when interest rates fall? Falling interest rates act like a high-octane fuel for stocks—they boost returns. The secular decline in interest rates in the 1980s and 1990s was a major contributor to the powerful bull market in stocks over that period.

Today, the stock market’s supply of high-octane fuel is exhausted. Bernanke and Co. have driven short-term interest rates as close to zero as they will get and the recent flight to U.S. Treasury securities has pushed long-term yields below 3%. Interest rates can’t fall much further from here and the risk of much higher rates in the medium term is frightening. There is over $1 trillion in excess reserves in the banking system and the federal government is issuing treasuries like they are going out of style. If the Fed doesn’t drain reserves and the government doesn’t reduce the deficit, interest rates will move much higher and stock prices much lower.

Without the tailwind of falling interest rates, capital gains will be harder to come by. And if interest rates make a decided move up, forget it—capital gains will become folklore. Portfolios short on dividend-paying stocks are most at risk in the current environment. Cold hard cash in the form of dividends offers protection against the threat of long dry spells in the stock market. If your stock portfolio is short on dividend payers, it is time to make a change.

An Alternative to Ultra-Low Treasury Yields

Jeremy Jones — Fri, 23 Jul 2010 15:34:12 +0000

The short end of the yield curve remains punishing for investors. Yields on two-year notes are now below the lows reached at the height of the financial crisis, and five-year notes yield a scant 1.68%. Going out longer on the yield curve still isn’t an answer to paltry yields, though. Long bonds are significantly overvalued from both long- and short-term perspectives.

The low level of Treasury yields is both frustrating and maddening.

Policymakers are attempting to recapitalize the banking system by engineering a steep yield curve. The Fed has essentially lowered the risk-free interest rate to zero. The losers in the scheme are the savers and retired investors who depend on full-faith-and-credit short-term Treasuries and CDs to fund living expenses.

Fortunately, there are still opportunities to pick up decent yields in investment-grade corporate bonds. The big down-tick in Treasury yields has not been matched by an equal down-tick in investment-grade corporate yields. In other words, spreads have widened, allowing you to pick up additional income without reaching for yield in long bonds or low-quality credits.

In Young Research’s Global Investment Strategy we help investors craft diversified corporate bond portfolios that offer a healthy yield advantage over U.S. Treasury securities.

A Raging Bull Market in MLPs

Jeremy Jones — Thu, 22 Jul 2010 17:59:02 +0000

The raging bull market in MLPs shows no signs of slowing. Since the S&P 500 peaked in October of 2007, MLPs have gained more than 33%, while the S&P 500 dropped 25%. YTD, MLPs are up 17%, compared to a loss on the S&P 500.

Raters Now Liable for Mistakes

Jeremy Jones — Wed, 21 Jul 2010 13:33:12 +0000

Bond Sale? Don’t Quote Us, Request Credit Firms – Anusha Shrivastava, The Wall Street Journal
“Standard & Poor’s, Moody’s Investors Service and Fitch Ratings are all refusing to allow their ratings to be used in documentation for new bond sales…Each says it fears being exposed to new legal liability created by the landmark Dodd-Frank financial reform law…The new law will make ratings firms liable for the quality of their ratings decisions, effective immediately…That is important because some bonds, notably those that are made up of consumer loans, are required by law to include ratings in their official documentation.”

IMF Shifts Advice to Banks on Asset Bubbles – Bob Davis and Tom Barkley, The Wall Street Journal
“The International Monetary Fund’s executive board said central banks may want to use interest rates in a “limited” way the next time they encounter an asset bubble that needs to be pricked…”the combination of rising asset prices and rapid credit growth may warrant a higher policy rate,” the IMF paper said…Some Fed researchers say that loose monetary policy can play a role in promoting asset bubbles by encouraging banks to take on too much leverage and that small changes in interest rates could help tame bubbles.”

Big Troubles in China

Jeremy Jones — Tue, 20 Jul 2010 15:40:29 +0000

Hong Kong’s Populist Turn – Review & Outlook, The Wall Street Journal
“Hong Kong’s prosperity was built on its economic freedom…So it’s alarming to see the territory’s leaders turning their backs on that tradition…Hong Kong became wealthy by resisting the statist fashions of the postwar West. It would be tragic if it adopted those fashions just as we are re-learning the damage they can do.”

Chinese Banks: Informal Securitisation Increasingly Distorting Credit Data – Chu, Wen, and He, Fitch
“Against this backdrop, the reported deceleration in lending in H110 (Chart 1) has received much attention. The slowdown is cited as evidence that recent administrative tightening is working, and that China’s banks and economy are normalizing after the shock of 2008‐09. While the credit environment is less frenzied than in H109, Fitch Ratings cautions that lending has not slowed nearly as much as official data suggests, due to the increasing amount of credit being shifted off of Chinese banks’ balance sheets via informal securitisation (ie the re‐packaging of loans into investments products for sale to investors)…Fitch believes the vast majority of these transactions are not publicly disclosed by Chinese banks, and few, if any, traces of the loans remain in financial statements. The growing popularity of this activity is increasingly distorting credit growth figures at an institutional and system level, resulting in pervasive understatement of credit growth and credit exposure. Consequently, Chinese banks’ loan loss reserves and capital are more exposed to credit losses than current data suggests…Adjusted for informal securitisation activity, Fitch estimates that the net amount of new CNY loans extended in H110 was closer to CNY5.9trn, or 28% above the official figure of CNY4.6trn.”

Vanguard CEO’s Biggest Worry

E.J. Smith — Thu, 15 Jul 2010 19:43:10 +0000

You can probably count on one hand the people you trust to give you sound investment advice. For a number of reasons, talking about money even with them isn’t always the easiest thing to do, and often it’s worse than talking about religion and politics. Trust is paramount.

Two companies that have gained the trust of individual investors are Vanguard and Fidelity (disclosure: Richard C. Young & Co., Ltd., invests in some Vanguard funds and uses Fidelity as a custodian for client accounts). Billions of dollars have poured into both firms while less desirable firms have dealt with net outflows. You may have seen Vanguard’s advertising campaign called “Vanguarding.” It deals with trust, and among other things reminds investors that “Reacting to the stock market is just investing. Taking stock in the long term is Vanguarding.”

This week’s Wall Street Journal feature, “Small Investors Flee Stocks, Changing Market Dynamics,” by E.S. Browning, tells the story of how Karen and Roger Potyk lost $75,000 on a Lehman Brothers bond, leveling a devastating body blow to their confidence. “In the military, you learn that you want people you can respect, trust—who have integrity,” Mr. Potyk says. “Over the last five years or so, I find that our financial institutions have no shred of the character I describe.” The Potyks sold their stock mutual funds in May.

The problem for the Potyks and investors like them is where to go with all that cash. The Potyks and a large herd of investors seem to think bonds are the answer. Vanguard CEO William McNabb warns in a recent interview with Fortune that “The single biggest tactical investment issue I’m worried about is that we as an industry saw $400 billion flow into bond funds.” The following chart from the Investment Company Institute (ICI) illustrates this point. Note how investors have chased the low-hanging fruit of above-average bond returns seen in 2009. Bond returns like that are never going to been seen again in most investors’ lifetimes. Also, note how over the course of the series investors often chase returns by increasing inflows to bonds after performance turns up, missing out on early gains, and how they experience the worst of the declines by selling too late.

Bonds need to be in your portfolio. It would be a mistake, though, to leave your bond holdings exposed to the inevitable sharp upswings in interest rates. Vanguard’s Mr. McNabb concludes, “We hope that investors remember that if interest rates go up, bond prices go down. We’ve tried to be very aggressive in education about that.” The Potyks may have made another mistake—one that could have been avoided if all along they’d been working with someone they trust.

Gold ETFs and Gold to Go

E.J. Smith — Thu, 15 Jul 2010 19:36:10 +0000

Notable & Quotable – The Economist, The Wall Street Journal
“Investment in gold ETFs and similar products reached a record high in 2008, of 321 tonnes—and then almost doubled, to 617 tonnes, last year. The stock of gold held by such funds more than doubled to 1,839 tonnes in the two years to the end of 2009…The 229 tonnes of gold sold in the form of official coins last year was the most since 1986, thanks to demand from retail investors in America and Europe…In Abu Dhabi those seized by an urge to buy bullion can now head to the lobby of the Emirates Palace hotel, where the Gold-to-Go machine dispenses bars.”

A Simple Strategy for Stock Market Success

Dick Young — Thu, 15 Jul 2010 15:00:51 +0000

For over four decades I have used a simple strategy to successfully invest in the stock market. I invest exclusively in dividend paying stocks. I especially favor those with high yields, a strong balance sheet, and a history of annual dividend hikes. This strategy is simple, but it works.

Historically, high dividend payers have outperformed non-dividend payers. In the chart below I show the growth of $1 in non-dividend paying stocks to the growth of $1 in the highest yielding quintile (top 20%) of U.S. stocks. The difference in performance is profound. $1 invested in non-dividend payers in June of 1927 grew to $696. That same dollar invested in the highest quintile of dividend paying stocks rebalanced each year, grew to over $4,500.

You may study my chart and wonder why any investor would bother with non-dividend payers. This strategy is not complicated. Anybody with access to a financial database and some time can run a few screens and come up with a list of candidates to buy. As I see it, the reason more investors don’t focus exclusively on dividend payers is because they lack patience. Building wealth in dividend paying stocks is a slow process. Most high dividend payers are mature stable businesses with modest growth prospects. They don’t offer the prospect of spectacular short-term gains. With dividend payers, you profit over the long-term through the power of compound growth. That requires patience.

At Young Research my Retirement Compounders list includes only dividend paying equities. Today, the average dividend yield on the RC’s exceeds 5%–more than twice the yield on the S&P 500. Young Research’s Retirement Compounders forms the basis for the stocks I recommend in Intelligence Report and the equity portfolios we manage at my family-run investment company.

The performance of Young Research’s Retirement Compounders is updated weekly on my website. YTD the RCs are up .1% compared to a 2.2% loss on the S&P 500. My goal is not to outperform the S&P 500. In fact in bull markets dominated by low quality stocks, such as this one, I expect Young Research’s RCs to lag the market. The RCs recent performance is somewhat of an anomaly. With the RCs my goal is simply to earn a steady stream of cash for my subscribers and money management clients.

For recommendations on individual dividend payers you can sign up for a subscription to Intelligence Report or Young Research’s Global Investment Strategy which focuses more on internationally listed dividend payers. To form a global dividend focused portfolio you’ll want both. If you are interested in having a portfolio of global dividend paying equities managed check out younginvestments.com.

Avoid Australian Equities?

Jeremy Jones — Tue, 13 Jul 2010 18:21:19 +0000

The correlation between Australian stocks and Chinese stocks is near a record high. If you are bearish on China, you probably want to avoid Australian equities.

Stop Losing Money in ETFs

Dick Young — Fri, 09 Jul 2010 19:10:30 +0000

You may be thinking about using fixed-income ETFs to fill out your portfolio. Don’t. I continue to avoid fixed-income ETFs, as should you. The low liquidity of many bonds creates wide discount/premium gaps between the price and the net asset value (NAV) of the funds. If you buy the fund at a premium, you’re whacking yourself with a notional loss right out of the gate.

For quick proof, take a look at my chart of the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD). The top part of the chart shows the price and net asset value (NAV) of the fund. If you buy the fund when the price is higher than the NAV, you’re buying a dollar for more than a dollar.

In green on the lower part of the chart is a representation of when the fund has been selling at a premium, or for more money than the bonds represented are worth on the open market. See how little red is on the chart? There doesn’t seem to be much of an opportunity to buy the underlying bonds for what they’re worth, let alone at a discount. Don’t forget about selling. Look at the dip in September on my chart. September sellers of LQD sold their shares for up to 11% below what they were worth. The illiquidity of the underlying portfolio of fixed-income ETFs makes investing in them a fool’s errand.

Modest yields today mean that if you pay more than 1% above the NAV, you could be giving up more than a quarter of your return in the first year. Even worse, imagine buying at a 1% premium and selling at a 1% discount. You’ve lost 2% in simple NAV misvaluation.

I continue to favor open-end mutual funds and individual bonds for my fixed-income portfolio, and so should you. For individual bond recommendations, subscribe to Young Research’s Global Investment Strategy.

YoungResearch

High-Octane Fuel for Stocks

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