Bernanke: "Let's do the twist."
It’s an odd world we live in. The Federal Reserve announced what we all already knew—that slow growth and weak demand would be with us for a while—and yet this sparked a market panic that sent the Dow (DJIA) down by more than 500 points before it recovered slightly. And it wasn’t just stocks that fell. Commodities, as measured by the CRB index, sunk to a new 2011 low, and even gold—that so-called “crisis hedge”—had one of its worst weeks in years (GLD).
With the Fed taking a new direction in its efforts to boost the economy (“Operation Twist”) and investors rapidly losing faith in the economic recovery, it is a veritable minefield out there. Today we’re going to take a look at these developments and offer some suggestions for how investors can best position themselves.
What is Operation Twist?
The Fed is selling down $400 billion in Treasuries that have maturities due in three years or less and are reinvesting the proceeds in longer-dated bonds (anywhere from 6 to 30 years in maturity). The reason for this is pretty straightforward. Investment—whether it be in a new factory, an office building, or a house—requires long-term financing. By buying long-dated Treasuries, the Fed is attempting to lower the benchmark rate that lending in the private sector is based on. A factory that is marginally unprofitable or a house that is just out of your budget when financed at 5 percent might all of a sudden be doable at 4 percent. By keeping the yield on “risk free” Treasuries unattractively low, the Fed is hoping to encourage a little risk taking.
Will it work? Well…it depends on how you define “work.” At the margin, a few new projects will get done, which should at least prevent unemployment from getting any higher. And it certainly can’t be bad if cash-strapped homeowners are able to refinance their mortgages and free up funds that can be spent elsewhere in the economy.
But anyone looking for this to spur a robust recovery will be sorely disappointed. There are limits to what monetary policy can do. At some point you reach what John Maynard Keynes called the “liquidity trap,” the moment at which no one is interested in borrowing and spending, even at zero percent interest. If a company foresees weak demand for its products, it really doesn’t matter how low the financing rates are. Even at zero percent interest, it doesn’t make sense to do the project. And consumers who are already burdened with more debt than they can pay have no business borrowing and spending more.
I don’t mean to sound excessively gloomy; I’m actually cautiously optimistic and recommend that investors use the current volatility as an opportunity to shop for good investment bargains. But it should be obvious that the entire Western world suffers from overcapacity and excess supply in several key sectors—and most notably in housing and manufacturing.
Where Do You Hide?
The knee-jerk reaction to the gloomy economic news and the panic gripping the market is to dump your stocks and run to safe haven assets like gold and Treasuries. We’ll look at each of these options separately.
For most investors, it does not make sense to invest in Treasuries. The 10-year note yields a pitiful 1.7%, and if yields rise at all the price of these securities could fall precipitously. If you hold to maturity you have no risk of capital loss, but does it make sense to tie up your funds for 10 years for such a small return?
The answer for most investors would be a clear “no.” Treasuries have no value as an investment at current prices. Investors wanting to take some of their chips off the table would be better off simply going to cash.
Large institutional investors do not have the option of going to cash. No bank would want to accept “hot money” deposits of tens or hundreds of millions of dollars. And even if they did, the institutional investor would not want to subject those funds to the risk that the bank would fail. FDIC only covers $250,000, after all.
Individual investors can go to cash, however. Investors with large multi-million dollar accounts can split their deposits across several banks to take advantage of FDIC insurance. This makes lot more sense than buying overpriced Treasuries, though investors should hesitate before they convert too much of their portfolio to cash. The volatility has created quite a few attractive bargains; more details on those to come.
The other safe-haven asset on many investors’ minds is gold. Gold, however, has failed to live up to the task. After soaring to over $1,900 per ounce in the weeks following the S&P debt downgrade of the United States, gold has plummeted, falling more than $100 dollars per ounce intraday and having its worst week since 2008 . It appears that gold has shifted from a “crisis hedge” to being a “risk asset,” like stocks and commodities. Though it is too early to say, the gold bubble may indeed be bursting (see “Has the Gold Bubble Finally Burst?”).
While I understand the reasons for buying gold—disgust with the political antics in Washington and Brussels, loose monetary policy, a banking system that appears at risk, etc.—the price of this “insurance” has simply become too expensive. And given its recent price action, it’s value as insurance when it is needed most would appear to be in doubt.
So, where should investors put their hard-earned funds?
My recommendation might seem somewhat pedestrian, but high-dividend stocks would appear to be the best bet right now. Unlike bonds, the yield on dividend-paying stocks is likely to rise over time, regardless of what happens to stock prices. And unlike gold, dividend-paying actually trade at attractive prices.
When you reinvest your dividends, little spates of volatility like we’re having today can actually work to your benefit as they allow you to automatically purchase new shares at depressed prices. And even if the market trades sideways for years, you can earn a respectable return on the compounded dividends. In a world full of uncertainty, dividends supply a degree of stability that can help you sleep at night.
For a one-stop shop, investors might consider the WisdomTree Large Cap Dividend ETF (DLN). It’s loaded with companies that will survive and thrive even during financial Armageddon: names like Johnson & Johnson (NYSE:JNJ), Exxon Mobile (NYSE:XOM), and Pfizer (NYSE:PFE) among others.
Disclosure: Sizemore Capital currently holds shares of DLN in some client accounts.
About the author:
Mr. Sizemore has been a repeat guest on Fox Business News, has been quoted in Barron’s Magazine and the Wall Street Journal, and has been published in many respected financial websites, including MarketWatch, TheStreet.com, InvestorPlace, MSN Money, Seeking Alpha, Stocks, Futures, and Options Magazine and The Daily Reckoning.