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Tuesday, June 10, 2014

Is the Market in a Sweet Spot, or What?

Readers of this blog know I'm not a market forecaster.  They know I don't have a crystal ball.  They know that I subscribe to the low-cost, well-diversified index fund investment philosophy touted by Warren Buffett, Burton Malkiel, Dan Solin, and Andrew Hallam.  What some may not know is that I follow the markets closely and have been following and investing for over 30 years.

And,  just because you're an indexer doesn't mean you can't have a bit in the market seeking to outperform the market.  I recommend this be kept to 10% or less of total assets.  This is the "fun" account.

Anyway, having said all of this, I have to say I've been amused by the constant long-time parade of talking heads on CNBC predicting a market correction.  I understand the guru status meter and how predicting a downturn in the market that actually occurs causes the needle to go crazy.  I've been around so long I remember Gazarelli's call in 1987 before the market crash that saw a 24% drop in one day.  I watched as her notoriety ramped up big time.  And as it ramped down.

Like a broken clock, some of these guru wanabees will eventually be right and garner followers who reward them for their correct market call.  Most of these gurus emphasize that their favorite valuation measures are high (above some critical level) on an historical basis.

Anyway, since everybody and their brother seems to want to offer a view, I thought I would offer mine.  First off, I believe the backdrop in today's market is important, maybe more so than at any time in history.  The notion that "this time is different" is nonsense is nonsense.  Every market is different! Today interest rates are at historically low levels in the U.S. but higher than important rates elsewhere in the world, namely Germany.  The yield on the 10-year U.S. Treasury stands at 2.59%, a full 1.24% (124 basis points) above the similar offering in Germany.  For Europeans, the U.S. Treasury note is extremely attractive given their year-over-year inflation rate of 0.5%!  Throw in U.S. dollar strength, and it is a terrific investment for European investors.

Another huge part of the investment scene that makes the present different is the gray tsunami of the baby boomers retiring and scrambling to live off their retirement funds.  Many are stretching, for an extra 1% to 2% is important for their standard of living.

It is no secret that looking in the rear view mirror, although extremely costly at times, is the prevalent way of investing; and today that rear view mirror shows that dividend stocks have pulled up many income investors by the bootstraps.  Like the guests at the party passing around the secret message, gray-haired investors are noting the higher-than-Treasury-yield dividend payouts by the likes of Johnson and Johnson and are jumping on the bandwagon.

I look at all this in economic terms.  The safe dividend payers with rates above 3% are substitutes for fixed income.  Go back to your Econ 101 notes.  Remember how an increase in the price of apples resulted in an increase in demand for oranges?  Make the price of fixed income too high (i.e., keep Fed policy focused on low rates) and investors demand for  dividend stocks increases.  Especially attractive, when inflation is under consideration, is the potential for dividends to increase versus locked-in Treasury payments for the life of the bond!

Of course, other factors are in play as well.  The Fed is systematically reducing its Quantitative Easing by $10 billion per month at each session, and the Federal Deficit is narrowing.

I don't have a research assistant to run down a bunch of fund flow and Treasury foreign fund investment data for you, but I believe this behavior by marginal investors is an important part of the market that a lot of the gurus don't get.  That huge pockets of investors, both domestic and foreign, have driven spreads on junk bonds (and even junkier Euro zone members) to eye-popping tight levels and, consequently, now see the dividend payers as the way to go trumps the old "P/E ratios are above historical averages and therefore it is time to lighten up on stocks" message.

To the extent that this thinking is correct, a big threat to stocks is, in fact, rising rates that approach dividend yields.  In the absence of rising rates, stocks could continue chugging higher, despite higher valuations on an historical basis.  This is not to say other threats are not out there, including nut jobs heading up major countries.  It is to say that the odds favor continuing to exploit downturns in the market, as long as Treasury yields remain significantly below dividend yields on high quality stocks.

Just my 2 cents.

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