IQ Trends: "There's no Free Lunch"

08/12/2016 9:00 am EST

Focus: STOCKS

Kelley Wright

Managing Editor, Investment Quality Trends

Between 1929 and 1995 the Dow Jones Industrials — based on dividends — traded in a consistent range; when yields reached 6%, stocks were at extremely undervalued  and when yields fell to 3%, stocks were extremely overvalued, explains Kelley Wright, editor of Investment Quality Trends.

In 1995 that all changed — dramatically. Why is that? To be fair, the answer is a number of things: A long-term decline in interest rates; relatively benign tax policies; the rise of the personal computer and access to information via the Internet, etc.

The real fuel for the fire, though, was the advent of new financial structures. For decades the backbone of the financial system was the concept of fractional reserve banking, where each dollar on deposit could be leveraged to ten dollars of lending - a 10:1 ratio.

Part and parcel of this scheme was that lenders needed to keep sufficient reserves to protect against bad loans or times when credit was tight and liquidity was short.

While prudent, these reserves weren’t very productive, as they could not be loaned long-term at high rates of return, which in turn were a drag on the lenders’ earnings capability.

All of that changed with the creation of new structures called derivatives, which allowed lenders to put their reserves to work (loan out or invest) because the derivative contract would, theoretically, provide the same protections as did the reserves.

Of course this was all predicated on the belief that the derivatives would perform in the real world as they did on the computer of the math wizard that created them. And you know, perhaps if lenders had stayed within the 10:1 ratio, maybe everything would have worked out just swell.

It probably isn’t a stretch to assume that most of us can relate to a situation where we tried something on a small scale and it worked so well that we jumped to the obvious conclusion that if it worked in this instance, then clearly we should be able to scale it up, right?

Well, that’s what happened with derivatives. 10:1 quickly ballooned to 20:1, then 30:1 and you get the point.

So, all of this new found money had to go somewhere and the one thing you can always count on Wall Street for is to find or create places to put money to work.

Initially these monies went into the tech and dot-com booms, of course until they crashed and burned. No worries! Everyone should have a mortgage by Jove, and anyone who had a pulse and could fog a mirror could buy a house.

Coming full circle then these new financial structures blew the prices of equities and houses sky high, which led  to extreme overvaluation of the Dow Industrials and, eventually, the bursting of the credit bubble.

Query: Were these sky-high prices and valuations truly reflective of the underlying economic value of these companies? Clearly the answer is no as prices dropped precipitously through March 2009.

Since 2009, we have been watching the deployment of another set of new structures, but this time they aren’t from Wall Street, they are from central bankers.

I don’t want to re-litigate the efficacy of QE. There is a legitimate argument to be made that Bernanke et al, saved the world from a repeat of 1929. My concern, though, is that perhaps it has now been overdone, as were derivatives.

You see, what worked initially after the meltdown isn’t doing so well these days. Yes, asset prices are increasing, but is wealth and prosperity being created? Are corporations building new plants, starting new lines of products and services, hiring more employees?

Of course not, and why should they when they can buy a competitor, borrow money to buy back shares and increase dividends, and engineer their quarterly earnings reports to make their bonuses?

To tie this up there is, sadly, no free lunch. If asset prices aren’t reflective of underlying economic values then eventually an adjustment will be made, which we know is never pretty.

Of course no one knows when that will be, but the music will eventually stop and everyone will be scrambling for chairs.

I know, the S&P and Dow just hit fresh, all-time highs and technically that suggests further gains. Clearly the market believes it is getting another free swipe at the apple because the Fed won’t be doing anything anytime soon.

That being said I would advise patience. The category of historically undervalued stocks is thin and getting thinner.

The Dow Utility Average is, for all intents and purposes, at historically overvalued levels and the dividend yield on the Industrials is within a quarter of a point of the margin of error for being overvalued.

In short, I see more downside risk than upside potential, and the market feels manic to me. Those are conditions where I don’t think the risk/reward equation is on my side. As such, I am content with taking a breather. Tomorrow is another day.

Editor’s Note: Kelley Wright will be a featured speaker at the upcoming San Francisco MoneyShow, August 23-25. His workshops will cover such topics as the best growth opportunities around the world, deep value investing and the 20 best stocks to buy today. To register, click here.

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