Tuesday, March 30, 2010

Wall Street's "Yield" Obsession Will Not End Well

It was another green day on Wall St as investors continued to gobble up stocks.

I have recently taken a step back to re-evaluate the lunacy that we are witnessing in the stock market. Stocks as we all know have been risin practically everyday despite waves of bad news both here and abroad.

The market basically refuses to to acknowledge the fact that the economy has shown very few signs of improvement. The recovery bet is still on but I think the market is rising for another reason at these lofty levels.

Stocks have gotten way ahead of themselves at this point. even many of the market bulls are beginning to admit this.

IMO, the reason we continue to move higher despite no evidence of a recovery is because stocks and junk bonds are the only investment options left that offer any return. Think about it: Treasuries and CD's offer basically zero return.

As the baby boomers continue to walk away from the workforce, they are becoming increasingly dependent on yields in order to fund their retirement. Fund managers as a result are taking huge bets on junk bonds and stocks in order to produce the yields that investors demand.

The problem with such an investment strategy is it forces muntual fund and retail investors to into things like junk bonds that are overvalued and not fundamentally sound.

Example:

Let's take a look at what happened to (ORNAX) which is a higher yielding "junk" muni bond fund back in 2008 when the market got whacked:


My Take:

As you can see above, these higher yield funds perform well as long as the credit spreads don't blow out as a result of a loss of confidence in it's holdings.

Right now only 6% of ORNAX's holdings are rated AAA, and only 17% are rated A or higher. The of rest it's holdings for the most part are BBB and lower or in other words "junk".

When the market is rallying and the Fed is pumping money into the stock and credit markets markets these funds are OK to hold. If you grabbed junk bonds in 2009 they have been very good to you because the spreads on debt have been coming in.

The problem here is since we have no "mark to market" accounting, we don't have any real price discovery as to how much these assets are really worth.

This is extremely dangerous for anyone holding these investments because the risk of holding such "garbage" assets is not being appropriately priced into these holdings. As a result, you are basically holding a pile of "dog doo" in return for a high single digit yield.

What you need to ask yourself is what happens to this garbage when the fundamentals once again get priced back into the markets? Umm, just take a look above and you have your answer. (ORNAX) dropped from about $13 down to %5 in a matter of months.

So much for that more "secure" high yield bond investment.

The Bottom Line

What we are witnessing right now in the markets is a "flight to junk" versus safety in order to find the yields that are no longer available in treasuries and CD's.

As a result, stocks and bonds are both rallying because there is no other place to put your money that returns a decent yield. As a result, both have become ridiculously over valued.

The P/E ratios on stocks have now soared to over 100-1 in many areas of the S&P 500 which is worse than the tech bubble back in 1999!

This type of investing will end in tears because eventually the fundamentals ALWAYS matter. Make sure you take a look at your financial statements to see if you have been thrown into junk yielding investments by your financial advisor and make adjustments accordingly.

The stock market is insanely overvalued right now and mutual funds currently only hold only about 3-1/2% of their assets in cash. The last time we saw such low cash holdings was 2007 and we all know what happened after that.

IMO, you must be very risk averse after a 60% rally in the markets. I am in the process of tweaking some of my bond portfolios that included a few high yielding instruments.

Preservation of capital should be a high priority of any investment portfolio right now until we see more evidence of an improving economy. This should include a high percentage of treasuries, CD's, and money market funds.

Remember: Getting paid 6% holding a high yield junk fund doesn't look so hot when it drops 70% in value!

The same could be said for holding stocks that are rising as a result of being chased by a bunch of "bubble headed" mutual funds that are desperately searching for yields in order to satisfy investors.

It's time to "get out" when investors are buying stocks for no fundamental reasons whatsoever. You want to own stocks when investors are buying them based on the belief that their potential for growing earnings looks promising. One look at the economy should tell you that the chances of this are slim to none right now.

Most of the earnings growth we have seen has been a result of inventory builds and "Hocus Pocus" accounting.

Any positive earnings seen in the financial sector are the biggest joke of all. Right now they basically don't have to report any of their real losses because the accounting rules are allowing them to hold obvious "distressed" assets at full value. The whole earnings game in this sector is nothing but a sham.

Be careful out there folks. Don't be the retail investor left holding the bag when Wall St decides to hit the SELL button when this game of "hide the sausage" is over.

Disclosure: Currently bond holdings include (PTTRX) (JENSX) (JAHYX).

22 comments:

getyourselfconnected said...

Great points. Chasing yield always ends bad, but the fun is in the trying I guess. Here we come S&P 1350!

Herb said...

How long until there is a stampede to exit stocks?

Jeff said...

Get/Herb

Yep

I wish I had the answer as to when.

All I know is the 10-15% upside is not worth risking the downside of 30-50% or more IMO.

Good luck to all bulls and bears.

flipdippy said...

The george foreman market...knocked around like a $2 french prostitute but never ends up going down.

With news like this, you guys are NUTS to stay on the sidelines!

http://dealbook.blogs.nytimes.com/2010/03/30/california-queries-banks-about-swaps-on-state-debt/?partner=yahoofinance

Anonymous said...

The rally in stocks is entirely rational. The recently passed Health care bill relieves business of providing health insurance which is tantamount to increasing earnings.
Just as the American corporation benefited from the transition from defined benefit pensions to 401K the Health care act will only encourage corporations to jetison health care coverage for it's employees.

Herb said...

Stock market rational?

LOL!!

Jeff said...

Flip

LOL

The jobs number on Friday might finally take George down for the count..LOL

The ADP number was drastically below consensus.

Wall st is lucky the market is closed on Friday.

Jeff said...

Anon

Good luck with that thesis.

The healthcare legislation was nothing about healthcare.

It was a large tax increase that allowed the government to increase revenues that are needed to finance our deficit.

They now have four years of tax revenue before this piece of garbage legislation takes effect.

There may be some benefits in certian ways but there will be negatives as well:

Increased taxes are never helpful for business growth.

Let's see what this monstrosity looks like before we discuss it. I can't see it being any type of positive for business or the economy.

getyourselfconnected said...

Anon,
I would think At&T and others would disagree with you but by all means go double dog dare long SPY on that one.

Anonymous said...

Anon- the thought that the health care reform will benefit co.s, who do you think is going to pay for this? Companies are already taking $$ as a fist quarter charge for this program, example Boeing took $150 million. Don't worry, one way or another we all will pay for this unless your either very poor or very wealthy.
Regarding this post about yield, I find it very timely, it almost strikes me as a bear trap, they have laid the scent down and it is only a matter of time the hungry (for yield) suspect sticks his neck out and then SNAP!!!

Herb said...

Companies were very quick to come out with press releases on how much money they would lose. I think they were planning on canceling retiree medical benefits and now can put the blame on the new health care legislature.

Jeff said...

Herb

Interesting take.

Health insurance is a nightmare for corporations because the annual costs are soaring.

It will be interesting to see the impact of this reform as it starts getting implemented.

getyourselfconnected said...

You can see a preview here in mASSachusetts; price controls announced today for our own socialized health care. Nice!

Jeff said...

Get

Yeah..You guys are way ahead of the curve.

I have a friend up there that has to wait until late 2011 to get a checkup because they are so booked up.

Thats nuts!

getyourselfconnected said...

This state is messed up and it is not due to heavy rain!

Drop me a line Jeff, how are things?

Anonymous said...

The Housing Time Bomb: The bomb that didn't go off.

LOL

Anonymous said...

From the uber-bear Doug Kass:

"I am fully aware that my mistakes over the past few months have been numerous and far-reaching. Above all, I have been steadfastly skeptical regarding the sustainability of the domestic economic recovery and in the view that the foundation for a sustained move in the U.S. stock market was on shakier ground than the consensus believed."

http://www.thestreet.com/story/10708164/1/kass-moving-on.html

Anyone think Jeff will eventually step up and eat a big shit sandwich like Kass did? My guess is he doesnt have the stones to do it, insisting he is still somehow, someway, "right".

jeff said...

Anon

You think we are past this now?

Happy Days are Here Again?

Good luck.

I have made several mistakes like everyone does and admitted them.

Anyone that thinks that they have figured this game out will always be wrong.

I have always preached diversification.

I love you anonymous bashers...you crack me up.

I will always be learning as an investor and I am smart enough to realize that they can never be mastered.

The new casino/speculative investor has made the market very difficult to predict or decipher. You might as well go to the craps table in Vegas.

I will stick yo a few small bets and wait this one out.

Eventually the fundementals come back. For now, Party on bulls:)

jeff said...

"The Housing Time Bomb: The bomb that didn't go off."

Oh it didn't?? 50-70% drops in Florida and Vegas aren't housing time bombs?

This blog started in the beginning of 2008 before the shit hit the fan.

I have been wrong on many things, but I think if you asked the street as to wether or not a housing time bomb detonated the overwhelming answer would be yes.

jeff said...

FYI

I will be back when I have time.

Work is very tough right now and I haven't had the time to write.

Good luck to all out there. Not much to comment on anyway. The market has been very quiet.

Earnings season coming up.

Intel beat nicely. That should help tech. Let's see how corporate earnings look.

Best of luck to all out there with your investments.!

Anonymous said...

The funny thing about investing and the market is at one point in time you are right and at another wrong. Back in the late 90's and 2000's I was putting most of my savings in cash, I did invest as well but most of the savings went into cash & there were many times I felt foolish but the reality was that cash was a better performing investment over the past decade. My point being, for many years I was wrong but then I was right, so diversification is super important so you can be right or wrong all the time. Regarding the housing time bomb not going off, actually it is still exploding, another 1.8 million forclosures expected this year, 1 million next year and 800K in 2012. If this comes to fruition then maybe the market has risen too far too fast, with an S&P p/e of close to 22 and a 1.8% yield it certainly does not look cheap. Have fun boys & girls.

jeff said...

Anon

Well Said.

The bullfest continues today.

S&P up another 11 points today. This is turning into a feeding frenzy.