The one-and-done crowd has taken over. The investors who read the tea leaves Thursday believe when the Federal Reserve takes action next week it is going to say this hike will be our last for a while as we need to study the situation.
The Fed, on background, has leaked that we could get a quarter-point increase and then a forceful statement that nothing will happen again unless there is concrete evidence that U.S. job growth is accelerating.
Now I think most of you who have never played the "rate hike, rate cut" game probably think this statement gaming is just silliness. I think we need to discuss why it both is and isn't a dumb parlor game that we need to put up with because of the opportunities it might give us if we are good and ready.
First, let's understand the fundamental concept behind the bull market that we have had and why it has gotten tenuous of late.
With bonds yielding so little there's been a mad scramble for income wherever it can be found. Younger people may not understand this. After they have put away their first $10,000 in an index fund, they want to buy the highest-growth stocks because those have the most opportunity. That's fine. Facebook (FB - Get Report) , which is part of the Action Alerts PLUS portfolio, Amazon (AMZN - Get Report) and other companies they use, such as Netflix (NFLX - Get Report) or Fitbit (FIT - Get Report) , are quite exciting. They can take the risk with these. They have their whole lives and all of those paychecks to make the money back if they end up picking a GoPro (GPRO - Get Report) or GrubHub (GRUB - Get Report) or some other stock that sounded pretty cool when it came public.
Older people who can't take that risk because they don't have as many paychecks in front of them instead want some capital preservation and yield.
We have had very few opportunities for income because rates are so low. You can own 10-year Treasurys and make 2% and change, but that's a mighty small amount to lock yourself into. But if you do anything shorter than that, you buy something with less time to maturity and you could end up with a percent or even less. That's the equivalent of not saving at all.
So that has driven investors' money toward stocks that can give you yield. Sometimes people invest in stocks with stable dividends, stocks such as Procter & Gamble (PG - Get Report) , Kellogg (K - Get Report) , Pfizer (PFE - Get Report) and Kimberly-Clark (KMB - Get Report) . Other times they reach for more income by taking more risk, perhaps by buying stocks such as Kinder Morgan (KMI - Get Report) , which boasted endlessly of steady increases in distributions, only one year later to cut the same dividend that it said it would keep growing from 51 cents to 12.5 cents, a 75% Freddy Krueger-like slashing.
Another way to get yield is to buy into an emerging market bond fund with similar outsized returns. These are marketed very aggressively by fund managers who sound so convincing that there isn't that much risk that they win over a lot of adherents. I think it is shamefully risky, but people can get talked into anything.
Now, what do all three of these kinds of buyers -- the Procter buyer, the Kinder Morgan buyer and the emerging market bond fund buyer -- have in common? They don't want to be doing what they are doing.
They don't want risk. They think that it is imprudent to buy a huge percentage of stocks with their savings, but they feel they have no choice. When you consider the folly of owning something such as Kinder Morgan, which obliterated your savings, when you thought it might be like a bond with an ever-increasing yield -- not because the stock was going down but because the distribution was going up -- you can understand the skittishness. Savers didn't sign on for that kind of risk. And with the economy getting weaker and many resource companies offering outsized tempting yields, there will be more Kinder Morgans, not fewer of them.
But risk isn't the only real enemy of those who are in these three different higher-yielding products. It's the possibility that the long-dormant bond market might begin to give you a better rate of return than you can get now. No, it's not going to be a better return initially. A quarter-point addition to a very low- yielding certificate of deposit really doesn't do it for most savers.
However, if rates are going to climb over the next year, with multiple rate hikes, that's a different story. If you get many rate hikes, then it would be prudent to sell all three kinds of income producers. You want to sell the Procters because their yields aren't so much better than bonds that if the stocks went back to where they were not that long ago, you would be under water. In other words, the dividend gain is not worth the principal lost. Which would you rather own, a bond that yields, say, 3% where you get your money back at the end, or a stock that yields 3% but plummets 10% because the stock market goes down or Procter had a weak quarter? So, you are a natural seller.
As for the people who reach for yield: Here's something that I am going to put into your head for the first time. Beginning right now after Kinder, if you own a stock that must borrow money to pay for that dividend, you are going to be taking on more risk than I can fathom at this point. That's because when the Fed starts tightening and the business the company is in,, like oil and gas, isn't doing well, then I think you are now courting another Kinder, which has become the benchmark of bad -- a stock that you were hoping to get an 8% yield from that you lost 60% on and had a whopping tax bill to boot. Dividends funded by debt -- funded by borrowing money and not from the core business -- are too risky from now on.
If you are in the emerging markets, lots of the bonds these managers are putting you into are very risky as the companies behind them might be borrowing in U.S. dollars but must pay off their debt and the distributions in currencies that are getting clobbered versus the dollar.
So all three attempts for more yield begin to backfire if the Fed is going to start the so-called process of normalization of interest rates.
And all three holders are going to be skittish like they were in the last three days. When we got press reports that the Fed will be very slow and very deliberate, that the Fed understands that they are in uncharted territory, then the urgency to leave these kinds of better yielders diminishes --- if, in fact, we hear a statement that says something like, "We will raise rates, but if the economy weakens ever so slightly or if layoffs pick up, then we won't take more action."
That makes it so the exit ramp isn't so crowded and there's less of a stampede on the way out. Remember I said Tuesday and the day before not to sell into a panic because it is not a strategy? I say that because of days like Thursday where you can get much better prices on the go out.
Now, here's where I come out on this. The Fed is fickle and speaks with many tongues. Friday, one of loose cannons on the Fed could be angry at these press reports and tell a reporter that it would be prudent if short-term rates were at one-and-a-half percent next year at this time, which would imply multiple rate hikes in rapid fashion. I would not put it past one of the more sanguine Fed heads to say 2% is more like it.
So here's my suggestion to you in these kinds of income-producing vehicles because you are reaching for yield and not because you believe in the investments: I think you should sell some of them right into this strength, maybe as much as a quarter of what you own if it is the first group, the Procters, half if you are in anything that looks like a Kinder and all if you are in an emerging market fund. You may not be able to make up the losses with that income. I am picking an up day to make this point so nobody thinks I am panicking.
I need you to get used to this parlor game of rapid hikes versus "one and dones" and to steel yourself and your portfolios when things are good, so when the rumors get tough you will be able to tough it out without selling into a maelstrom like Wednesday. That's because I know many of you don't like risk. It's just been a very long time since you've tasted risk, and you are beginning to realize it does have a little of that E. coli kick to it.