We wrote recently about the fact that money is flowing more into bond funds than stock funds as an aging population seeks income due to an artificially low interest rate environment. The demand for income by an undersaved population that have seen years of savings wiped out by two nasty bear markets since the turn of the century are plowing money into income producing assets at a rapid pace. The question is whether these individuals are again making the same mistakes of the past of the unintended consequences of markets driven by artificial influences.
During the 2004-2007 bull market cycle investors chased equities, commodities and emerging markets investments as the housing and credit expansions fueled the artificial wealth effect. As the credit bubble crested investors clung to their investments as market analysts and economists were proclaiming that things were “contained.” They were not – and the damage to retirements, and individual’s lives, was devastating.
Since then these investors have shifted their mentality from chasing equities to finding yield from stocks and bonds. Bob Farrell once stated that “investor’s buy the most at the top and the least at the bottoms” meaning that individual investors tend to react emotionally chasing the best performing assets right into the bust. The chart shows the BofA Merrill High Yield Index.
First of all, it is critically important to understand that “high yield” is jargon for “junk bonds.” In other words, “high yield bond funds”, which is a great marketing moniker for the uninitiated, means that the fund owns the debt of companies that are less than credit worthy. These companies are much like your cousin who asks to borrow money from you, and promises to pay you back, with a high rate of interest. The problem is that he has a very spotty employment record, does not manage his finances well, and has no money currently to his name. Do you lend him your money? However, this is exactly what investors have been doing in droves over the last three years.
The problem is that this does not typically work out well. The next chart shows the spreads between the AAA-rated 10-year treasury and BB rated corporate bonds (BB is the best of the junk bonds – uhh, I meant, high yield bonds) as well as the S&P AAA-rated bonds and BB rated bonds.
Importantly is that historically, when yield spreads are at current levels, it has been indicative of economic problems. When the economy stumbles – these “high yield” bond issuers tend to go bankrupt at an alarming rate. The Fed’s intervention with QE 2 in 2010 is credited with keeping the economy from sliding into recession. The question is will QE 3 have the same effect? Investors are currently “all in” betting on QE 3 pushing spreads to levels that are historically alarming.
Investor’s have also been chasing stocks with the highest dividend yields in their quest to increase income. The number of companies that now pay a dividend is 402 which is a level that has not existed in 13 years. More than 70% of those companies, which have already been paying a dividend, have boosted it within the last twelve months as uses for cash stockpiles are limited due the sluggish economy. That is the good news. The bad news is that investors have been piling into these same companies pushing valuations well beyond normal ranges. The chart shows two things: 1) rising dividend yields are associated with negative annualized returns in the S&P 500 and 2) the spread between the 10-year treasury rate and dividend yield is currently at levels associated with negative market returns. This is a warning – not a prediction.
The problem for those heading into, or in, retirement is the quest for income and safety. After the last decade the “return OF capital” has become much more important than the “return ON capital.” With a sluggish economy affecting wage income, interest rates at historically low levels, and current standard of living costs on the rise – investors have been systematically pushed into chasing yield. The continued artificial supports and interventions by Central Banks, both domestically and globally, have led to a false sense of security that markets will continue to travel upwardly, and “high yield” bonds will continue to pay, indefinitely into the future. That event is as unlikely as subprime loans being “contained.”
It is important to understand that I am not saying that a recession or market crash is about to happen. The markets, especially when running on “hope”, can remain elevated for far longer than logic would dictate. However, reversals in the economy, and the markets, come very quickly and will blind side investors lulled into a false sense of security. Will you be paying attention? [rate]
Images: via Flickr (licence attribution)
About The Author
Lance Roberts – Host of Streettalk Live
After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.
Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.
Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.