Corner of Wall & Main: Thirst for Liquidity

 | Jul 31, 2014 | 10:00 AM EDT
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As July comes to a close, the markets have continued to push higher, albeit with some recent sputtering of that rocket, despite a wave of geopolitical tensions and a weak, but (fingers crossed) strengthening domestic economy.

All the major averages are up for the year, except, what's that little green one down there?  

You'll notice that one tracked quite closely with rest until recently. That would be the Russell 2000, which is a subset of the Russell 3000 Index and represents about 10% of the total market capitalization of that index. It's the small, publicly-traded companies in the U.S. equity world. It is probably somewhat intuitive that smaller companies are, pretty much by definition, riskier and less liquid. Just think about how many shares of Apple (AAPL) trade a day vs. some very small company of which you've never heard. So we can see here that recently there has been a move away from less liquid stocks into more liquid, which are the larger-capitalized, more-widely-traded stocks, an indication that concerns over changes in liquidity levels are emerging.

If we look at bonds, we see a similar move away from riskier, less liquid bonds.  The chart below shows the performance of the iShares iBoxx Investment Grade Corporate Bonds ETF (LQD) (in red) and the performance for the iShares iBoxx High Yield Corporate Bond ETF (HYG) (in blue), otherwise known as junk bonds.

You'll notice the same pattern here in which the performance for both was rather closely aligned until recently, when the high-yield bonds suddenly began a rather dramatic decline as the quest for increased liquidity hit. Much like the difference between small-cap and large-cap in the prior chart, high-yield bonds are considered higher-risk bonds, (resulting in the higher interest rate), which means they are considered less safe and tend to be less liquid than the lower risk investment-grade bonds, particularly when markets get nervous.

This move into more liquid markets is again emphasized if we look at sovereign debt yields, which have plummeted to record lows. According to Bloomberg, bond yields for at least nine nations in the eurozone have hit record lows, with either of them below the rate for U.S. equivalents.  With increasing demand for the most liquid of securities, prices for sovereign debt has risen, which results in falling yields.

So far, earnings this season have been surpassing estimates, which is nice to see, but needs to be viewed in the context of estimates that were quite subdued given the actual 2.9% contraction in the economy in Q1. The tough thing is that now the market is priced for absolute perfection. According to data from Bloomberg, the S&P 500 is trading somewhere at more than an 18x forward P/E multiple, which is even higher than the heady days of 2007 and is the highest it has been since 2007.  This means that stocks are essentially priced at the expectation of perfection, which as we all remember prom night, reality doesn't often measure up to expectations.

We've got some serious headwinds, with all those rather intense geopolitical tensions and the ramifications of changes in Federal Reserve policy. Five Fed presidents are pressing for not only the end of QE, but a rate hike this year. On Wednesday, we learned that not only that economy grew much more in Q2 than expected, 4% vs. 3% consensus expectations, but inflation hit 2.3% vs. 1.4% in Q1. That inflation rate is above the Fed's target, so fears are increasing that the Fed will end up being behind the curve with respect to managing the impact of all this liquidity. In the QE world, such good news for the economy can often become bad news for the markets as this means that not only has the probability of getting cut off from more of that lovely QE drug increased, but we are more likely to be put on an exercise regimen with rising fed fund rates as well. 

Investors usually get nervous about real estate and REITs in particular during a rising rate environment, so we wouldn't be surprised to see these take a hit in the near term. But that could be an opportunity for the savvy investor. Conventional wisdom says that if interest rates rise, valuations must decrease in order for the property to maintain a similarly competitive yield. The reality is there is no discernable link between investment yields (known as cap rates) and interest rates. Rather, factors such as future cash flows, earnings growth and economic health have a greater impact. Given that higher rates are often the result of a strengthening economy, this benefits property owners. In addition, those REITs, such as Realty Income (O), which utilize triple net leases, often do quite well in a rising rate environment. Realty Income also has an incredible track record of continually increased monthly dividends, which can be particularly beneficial if you grab the stock after it's been beaten up a bit.

For those who think that the shift away from easy money may not be a Goldilocks experience, there's Plum Creek Timber (PCL), an excellent natural resource company that provides an investment in timber, which has no correlation to stocks and is an excellent hedge against inflation, Trees keep growing year after year, regardless of what is going on in the markets, at central banks or on Capitol Hill.  Forests are both lumber factories and warehouses, giving investors ultimate flexibility on harvest timing, plus the longer you leave it in the ground, the more valuable it becomes. Additionally, underneath all that timber sits valuable land, which puts a fertile floor under the share value.

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