Markets Need to Get Off the Juice

10/07/2011 8:30 am EST

Focus: MARKETS

Kelley Wright

Managing Editor, Investment Quality Trends

When markets break down, they must heal, writes Kelley Wright of Investment Quality Trends.

Like all living organisms that have suffered a major trauma, the healing process takes time as the damaged tissue is slowly rejuvenated with new, healthy cells. One facet of this healing process for the markets is deleveraging.

Like professional athletes who use steroids to enhance growth or to heal quicker from an injury, governments and central banks have deployed the monetary equivalent of steroids to speed up the healing process. This regimen can provide impressive results, as illustrated by the advance from the March 2009 low to the May 2011 high.

What the markets are learning, as many athletes do, is that the results derived from steroids are not organic and therefore short-term, which, in the end, merely mask-over the symptoms of the underlying condition. Accordingly, when the treatment stops and the effects wear off, the underlying condition still exists.

This brings us to my central point: deleveraging is an incremental process; the mirror opposite of levering up. If deleveraging were achieved in one fell swoop, entire economies would be crushed and descend into depressions far worse than that of the 1930s.

Unfortunately, investors are impatient. As such, when each increment is completed, there is a rush to “get in at the bottom.” Of course, a stampede of buying drives stock prices higher.

When subsequent headlines suggest that oops, maybe this isn’t really over, there is a mad dash to cash, which of course drives stock prices lower. Voila…volatility.

Picking tops and bottoms is one tough row to hoe. I can count on one hand the people I know who are proficient at it over time.

But value investing isn’t about picking tops and bottoms. The value investor identifies good historic value, takes a position, then waits for the value to be fully expressed in the market.

The primary challenge for the value investor is after buying a stock not getting distracted by the fluctuations in price, which, admittedly, can be very volatile. Many investors will buy a stock, the market goes wild, and if the stock price is lower one day, one week or one month later, they kick themselves for getting in too soon. “Arghhhh! I could have bought it cheaper!”

Price is important because it is a component of yield. The key to value, though, lies in yield as reflected by the dividend trend.

Catching the meat of the middle of a rising dividend trend is a central facet of the Dividend-Yield Theory, which posits that buying within 10% of either side of the historically repetitive area of low-price/high-yield, and selling within 10% of either side of the historically repetitive area of high-price/low-yield, is the long-term objective for the value investor who wants to build capital and an income stream from that capital to meet current and future needs.

At almost any point in any market cycle, it is possible to acquire good historic value. While you are waiting for that value to be fully expressed and capturing that meat in the middle, you may have to endure a few, or maybe many, white-knuckle moments—65-plus years of massive leverage doesn’t get unwound overnight.

A side effect of deleveraging can also entail one or more recessions. The PIIGS (Portugal, Ireland, Italy, Greece, and Spain) are in a pickle. Germany and France have to decide whether to shore up the Euro or let it collapse. US banks are invested in European banks, and what happens there will have an effect here.

US corporations, on the other hand, are in great shape—lean, mean, and hoarding boatloads of cash. Valuations are also getting better all the time. The cash dividend for the Dow has been steadily climbing, and dividend yields for many of our Select Blue Chips are well in excess of the interest rate of the 30-year Treasury.

Will the broad market averages drop further? Who knows? October is traditionally very volatile.

Dow 10,000, 9,700? Sure, it could happen. Whether it does or not, I believe five years from now, investors will look back and say that the good historic values acquired within this time period will prove to have been one of the best buying opportunities since the 1975-1982 time frame.

Subscribe to Investment Quality Trends here…

Related Reading:

Related Articles on MARKETS