11/21/2012 12:30 AM ET|
Income investors, beware the bubble
Bonds and dividend stocks are looking pricey, and inflation will eventually take them out. Let's try to figure out how to keep the income coming in.
We are looking at a bubble in the market for income assets.
Money continues to pour into the government bonds of the United States, Japan, Germany and other "safe haven" countries, even though yields are negative (after adjusting for inflation) and even though some of these "safe havens" rank among the world's most indebted governments.
Dividend stocks, too, have risen to historic highs even as yields have dipped. For example, an index that tracks the Standard & Poor's 500 Index ($INX) "dividend aristocrats," a basket of 51 stocks that have increased their dividends annually for at least 25 years, hit an all-time high in October.
We all understand the reasons behind this love affair with income assets. Stocks have been scarily volatile for the past decade or more -- and threaten to become even more so. The world's central banks have flooded financial markets with cash, crushing yields, but at the same time promising to keep interest rates extraordinarily low for "an extended period," to quote the Federal Reserve. A sputtering global economy has resulted in low rates of inflation, and deflation often seems a more immediate threat.
But we know we're nearing the end of this cycle. Here's when the bubble might burst, and how to find income right now.
A bubble that will burst
The yield on two-year Treasury notes could drop below the current 0.24% -- that's a negative 1.96% yield at recent U.S. inflation rates -- but the yield is unlikely to go below zero. At some point -- mid-2015 in the Federal Reserve's most recent formulation -- the world's central banks will start raising interest rates again. A return to global growth, simple demographic pressures or the aging of the world's population will lead to higher inflation rates, which will make those paltry yields unpalatable.
And we all know the big questions, too: "When?" and "What?"
Knowing what we know -- about the likelihood this is a bubble that will eventually break -- when do we take action to avoid getting caught up when it bursts? And when we take action, what do we do?
We're all friends here, so let's be frank: Everyone investing in the markets for income assets believes he or she will be able to anticipate the breaking of the bubble with enough lead time to exit the markets.
Of course, financial history says that won't happen. Financial logic, indeed, says it is true only if you believe you will see the bursting of the bubble before everyone else does. If everyone sees it at once, we're looking at a mad panic at the exits. If just a large chunk of the market sees it coming, we're looking at the kind of move to the exits that accelerates the bursting of the bubble.
Moreover, timing the breaking of this bubble seems especially problematic.
The guessing game
Start with the Fed's deadline of keeping short-term interest rates near 0% until mid-2015. Of course, that refers only to the short-term interest rates over which the Fed exercises something like direct control. Long-term rates could well move up -- hurting bonds and other income assets -- before that, if investors see inflation or signs of future inflation, or come to expect future inflation. (Throw in the wild card here of the Fed's program of quantitative easing and its buying, under that program, of longer-term assets, including bonds.)
Of course, anybody who knows that the Fed's pledge is scheduled to expire in mid-2015 will decide to sell before then. That leaves income investors trying to decide when other income investors will decide to sell. Sounds exactly like John Maynard Keynes' lament that to pick the winner of a beauty contest (or winners in the stock market), you have to pick not the most beautiful face, but the face you think the other judges will think most beautiful.
"It is not a case of choosing those (faces) that, to the best of one's judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees," Keynes wrote way back in 1936.
That judgment is complicated by the difficulty of predicting major supply and demand trends in the income market -- and the effects of those trends on the price of income assets.
Right now, for example, because the Fed is buying assets for its program of quantitative easing, there's a shortage of new Treasurys, government-backed assets and investment -grade corporate bonds. Supply in those categories, which are currently in high demand from risk-averse investors, is forecast to go up by $1.16 trillion in 2013, according to RBS. But the Fed is projected to buy $1.02 trillion of that supply, leaving just $138 billion for investors. On the other hand, if 2013 or 2014 saw some solution to the eurozone debt crisis, the demand for "safe haven" assets will drop and offerings from more governments might qualify as safe havens.
Frankly, as unsatisfactory an answer as it may be, I think income investors who want to know the "when" can't do much better than watching inflation and inflation projections (to judge inflation expectations) and the direction of central bank policy. A switch from the current aggressively loose monetary policies at the Fed, the European Central Bank and the Bank of Japan to something like neutral would be a key indicator of a change in the weather.
More form MoneyShow.com:
MORE ON MSN MONEY
VIDEO ON MSN MONEY
Sorry Jim, I disagree with your take on Dividend Stocks - Bonds i agree on. Dividend stocks are a favorite of many Long Term Investors that are unlikely to sell them off because of rising interest rates.
Long Term Dividend Investors realize that as stock prices decrease their dividends buy them even more shares of stocks than would normally be possible. Dividend paying stocks are some of the best run companies out there, their monetary discipline has made them some of the most stable stocks. And last - It is highly unlikely that you will be able to earn a higher rate of return anytime soon than Dividend stocks. Where will you get it ? The Banks? Treasuries?, Bonds ( Whose bubble just burst) ? No , More than likely it will be many years before we can look for alternative places to park our money at as high of rates as dividend stocks so for me - Large, Iconic, Name Brand , Dividend Stocks is the place for me !
Copyright © 2013 Microsoft. All rights reserved.
Quotes are real-time for NASDAQ, NYSE and AMEX. See delay times for other exchanges.
Fundamental company data and historical chart data provided by Thomson Reuters (click for restrictions). Real-time quotes provided by BATS Exchange. Real-time index quotes and delayed quotes supplied by Interactive Data Real-Time Services. Fund summary, fund performance and dividend data provided by Morningstar Inc. Analyst recommendations provided by Zacks Investment Research. StockScouter data provided by Verus Analytics. IPO data provided by Hoover's Inc. Index membership data provided by SIX Financial Information.