Opportunity Vs. Risk in a Bifurcated Market

By Ilene, with guest author Paul Price at Market Shadows

The broad indexes are trading near highs. Many stocks are over-priced as judged by typical valuation metrics. However, the chart of the S&P 500 ETF (SPY) carving out major advances for most of the last six years does not tell the whole story.

S&P Chart from mid-2010:

SPY 5-years (weekly) (1)

Progress stalled about six months ago:

SPY YTD 2015   July 31, 2015 (1)

While the large-cap indices have gone sideways, many stocks have been crushed. Energy-related names have been hit hard. A few large winners in the cap-weighted SPY have been holding the average near its highs, but they are masking poor overall breadth.

Fears of an interest rate hike, perhaps in September or December, may be holding the market back. However, any increase in rates this year will be small, perhaps around 0.25%. Apart from a short-lived reaction by day traders, a small increase in rates is unlikely to have a major effect on stock prices. Even post-rate hike, absolute rates will be low. Income producing alternatives will still be scarce. The lack of risk-free returns drove indexes to higher than average P/E ratios in the first place. A small rate increase won’t change that.

When “safe” investments yield next to nothing, “risky” investments, like stocks, become more appealing, even when the S&P is near its all-time high. 

The price of the SPY alone does not determine the best place for new money. The attractiveness of alternatives is also important. And as for new money, many central banks are in “printing” mode. Due to the lack of alternative investments, the demand for stocks has kept US equities almost constantly moving higher. The demand has also lowered the risk of holding stocks. Huge corporate buybacks, using cheaply borrowed money (available due to ZIRP) has further diminished supply while boosting demand.

Only significantly higher rates would break this pattern. But there’s a problem with that.

America’s greater than $18 trillion, and growing, national debt suggests that significantly higher rates are not coming anytime soon. A 1% nominal increase on the average coupon rate that Washington pays would add about $180 billion per year to US’s annual debt service expense.

Raising money to pay off growing government debt, exacerbated by rate hikes, would force the issuance of even more debt. The US, unlike Greece, can and will continue printing money. The money printing (issuing more debt) would inevitably lead to much higher inflation. As many have said more succinctly, we cannot cure an unpayable debt load by issuing more and more debt. The cost of servicing that debt would become a true budget buster.

Thus, to keep the economy from derailing altogether, Obama cannot allow rate hikes on his watch. And the Fed works for the President. That is why interest rates will remain low, even though the Fed’s unemployment, inflation and GDP “targets” have been met. (Although as John Rubino points out, many of these targets risk being “unmet” shortly.) Fed Chair Janet Yellen will do whatever Obama instructs her to do even as she publically declares the Fed’s independence from political pressure.

Summing up:
1. Anything more than a token rate hike is probably not in the cards for 2015 or even beyond
2. The overall environment for equities is still favorable due to lack of good alternatives.

In this environment, we suggest avoiding momentum-fueled, overpriced stocks. Instead, look for good companies trading at low prices. My friend Paul Price likes out-of-favor stocks that fit the good company/good price model. His typical holding period is 12 – 18 months.

Here are some of Paul’s real money purchases. They are listed in no particular order of preference and span a wide variety of industries. Most of these companies pay reasonable dividends.

ASA Gold (ASA)
Franklin Resources (BEN)
Chemours (CC)
Eaton (ETM)
Flowserve (FLS)
Fluor (FLR)
Michael Kors (KORS)
Precision Castparts (PCP)
Scripps Networks (SNI)
Tupperware (TUP)
Valmont Ind. (VMI)
Viacom Cl. B (VIAB)
Whole Foods Markets (WFM)
Boardwalk Pipeline Partners (BWP)
Crane Corp. (CR)
Emerson Electric (EMR)
Fastenal (FAST)
Generac (GNRC)
Kelly Services Cl. A (KELYA)
Polo Ralph Lauren (RL)

As always, do your own research and determine whether any of these individual stocks meets your own investment needs and philosophy.

Disclosure: Paul is long shares of all companies listed above.

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