IQ Trends: Valuation Matters

03/13/2015 9:00 am EST

Focus: STOCKS

Kelley Wright

Managing Editor, Investment Quality Trends

Our raison d’être is value identification, which is to say we identify the repetitive areas of high and low dividend yield, explains Kelley Wright, editor of Investment Quality Trends.

This approach lets us establish the buying area with the least downside risk and the selling area that captures the lion’s share of price appreciation, dividends, and dividend increases.

I was recently interviewed, and asked, "What does IQ Trends do now that for all intents and purposes value identification is no longer necessary because the Fed has taken all of the risk out of owning stocks."

Huh? Are you kidding me? No, seriously, he really asked me this question with a straight face. As you might guess the balance of the conversation was me explaining why this was absurd.

Yes, investors have become complacent because we haven’t seen as much as a 10% correction since, oh, 2011. But complacency is the result of near-time bias; the belief that the most recent will last ad infinitum. Past events fade away in the memory until they are forgotten or dismissed.

The fact of the matter is that the Fed’s Zero Interest Rate Policy (ZIRP) will not last forever. At some point, interest rates will start to rise again.

In January, Chair Yellen stated that the long-term average yield on Fed Funds was somewhere between 4% and 5%, an area of normalcy the Fed would ultimately like to return to.

Let me tell you something, if Fed Funds go from 0% to 4% we’ll find out in a hurry that valuations absolutely do matter and that risk in the stock market is alive and well. This is not to say that it will happen overnight—in that case the entire system would collapse—but over the course of two to three years, you bet.

With Fed Funds and the entire Treasury yield curve back to an area of normalcy, which will impact the interest rates of all fixed-income instruments, the stock market will face competition from short-maturities such as T-Bills and CDs, to long-maturities such as 30-year bonds.

As a practical matter then, dividend yields and the risk premium will have to adjust to compensate investors for investing in stocks.

For dividend yields to rise sufficiently to compete against higher fixed-income yields, either earnings will have to increase significantly to support higher dividend payouts, stock prices will have to decline, or some combination of the two.

Earnings increases, over the long-term, are directly attributed to higher sales, which are the result of either a strong and growing economy or products and services that everyone absolutely has to have, period. These are facts that the Fed has absolutely no direct control over.

Heaven help me, during this interview, I was making an extra effort to be open-minded and understanding of this fellow’s premise, but thankfully we wrapped it up just before my head was about to explode.

In closing, there is widespread complacency among investors and in the market. Remember, though, that no trend lasts forever; economies and markets are cyclical, the last five or six years notwithstanding. At some point, the status quo will change; it always does.

Change is not a bad thing as long as you aren’t on the wrong side of change. I suspect investors that have thrown their lot in with the ‘valuations don’t matter’ crowd will learn this from the best teacher there is in the stock market; the hard—and entirely unnecessary—loss that hurts.

Over the long-term there is no free lunch in the stock market. If there were, there would be no stock market. In short, buy right; valuations matter.

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