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.


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).