Yield Kidnapped By The Fed? Why It Happened, And Today's Best Income Investments

by: Larry Meyers

It's time to clarify how quantitative easing affects the market. QE critics say it artificially props up the market, that it will cause inflation, and that it has killed fixed income investing. There is some truth to these criticisms, so here's what to watch for with stocks, why bond yields have cratered, and how to find other fixed income investments.

Demand Side

Normally, the US might see 1.8 - 2% real productivity growth and about 1% population growth. Consequently, real GDP growth should be around 2.8 - 3% annually. Instead, we're stuck in the 1-2% range.

The root cause for this slow growth goes back twenty years. The American consumer and government borrowed trillions against the future's GDP. Now, the American consumer is paying off that debt and it will take just as long to pay off as it did to accumulate, if not longer. Thus, the economy won't grow without having all that borrowed money.

So what can be done to keep the economy afloat?

That's where quantitative easing comes in. The Fed prints money to buy bonds issued by the Treasury. This keeps interest rates low, encouraging businesses to borrow at cheap rates, in order to help move the economy along.

It sounds good, but won't printing money cause inflation?

Why Printing Money Isn't Causing Inflation

Inflation is often defined as "too much money chasing too few goods," but in fact, it is "too much money and credit chasing too few goods." Think of each as a spigot, and both spigots need to be open and gushing for inflation to occur.

The reason we haven't seen much inflation over the past twenty years is because, as mentioned, the credit spigot was flowing but the money spigot was not.

Now, with consumers deleveraging, the credit spigot has been turned off a little bit. That allows the Fed to open up the money spigot a little bit and still not cause inflation.

With $50 trillion on the Fed's balance sheet, adding $500 billion in new money supply is not going to change that balance sheet very much, so inflation is kept in check.

Government Kills The Recovery

Now we know that, in theory, the Fed will be able to keep the economy afloat without causing inflation. Unfortunately, that's only half the story.

The economy can't recover because of too much government spending. The nation has a $1.1 trillion deficit, so the government must borrow to meet that deficit at a time when it needs to deleverage instead. However, it must deleverage gradually, at a rate that is offset by the 1-2% GDP growth that we are seeing.

Unfortunately, the government just keeps borrowing! Total public and private debt is around $55 trillion - that's 350% of GDP. Why is this level of debt bad? In Japan, just like here, the consumer has been deleveraging but the government has kept borrowing. The public debt as a percentage of GDP went from 70% to 220%. The result has been a twenty-year economic disaster for Japan.

So if America wants prosperity, the government must stop borrowing so much money. If it doesn't, the market may force it to in the form of a ratings downgrade, which will drive up interest rates, which slows the economy and decreases tax receipts, creating an even worse deficit… and a vicious cycle begins, which includes a stock market crash. That moves us towards Greece, which has the longest running recession (5 years) of any developed country in history.

So, as far as the demand side goes, everything might be okay if the government would just stop spending so much. That means the stock market is okay for the time being… until the ratings downgrades hit.

Supply Side

Now for the other side of the equation: how American businesses can grow GDP.

For GDP to grow organically, businesses need to produce goods and services. Unfortunately, there are many uncertainties that prevent businesses from investing capital.

Businesses want to keep costs low. The present Administration is fond of placing many regulations on businesses. Every regulation costs money to implement. Each $100 billion of regulations costs 0.7% in GDP growth, and this is growth we need right now. Thus, an Administration that wants to grow the economy removes regulatory burdens, rather than add to them, which is what has been happening.

There's uncertainty over Obamacare. Every dollar taken away from a business to fulfill this mandate is a dollar a company cannot spend to grow its business. Thus, businesses have been trimming hours and workers to avoid having to provide insurance.

That creates employment uncertainty. Those workers either lose jobs or work less, which results in lower earned income, which results in less spending to grow the economy and increase GDP.

So for the supply side, government is again getting in the way. Nevertheless, the stock market will be okay until a ratings downgrade hits.

However, this creates an investor caveat. When investors examine a stock, they must determine if its EPS growth is organic. Investors should subtract the effects of stock buybacks and cost-cutting measures from EPS growth. They should be certain the topline is growing.

How is this actionable?

Companies that are experiencing organic growth include low-cost consumer products like the dollar stores, such as Dollar Tree (NASDAQ:DLTR) or Wal-Mart (NYSE:WMT). Business travel remains solid, so upper-scale hotels like Hyatt (NYSE:H) are in good shape. Consumer staples will always play in this economy, as will fast food restaurants like McDonald's (NYSE:MCD).

However, the macro situation has created trouble for fixed income investors. The Fed's unceasingly purchase of bonds pushes yields down. Thus, those looking for fixed income won't find it in bonds for many years.

Consequently, investors are moving from bonds into stocks, in the hope of seeing improved returns. That's one reason why the market has been supported by the Fed's actions. As long as stocks provide more attractive yields, both from dividends and capital gains, all the capital from the bond markets will flow into the stock markets. The bond markets are massive compared to the equity markets. Thus, the stock market should be fine, barring any systemic shocks.

The stock market is likely to be further supported by China, which is also looking for better yields. China will not take the risk that exists in Europe. They will look to US stocks and American companies. Indeed, the Chinese company Wanda purchased the AMC movie theater chain. Expect more of this.

Consequently, be careful about some stocks that have gone way past their intrinsic value because of this general move into stocks. For example, I love Whole Foods Market (NASDAQ:WFM) but with a PEG ratio at 2.0, it's well beyond reasonably priced.

For those seeking fixed income, there are three places I would look. The first one is obvious - blue-chip dividend companies like AT&T (NYSE:T), Intel (NASDAQ:INTC), Altria (NYSE:MO), Philip Morris International (NYSE:PM), and Verizon (NYSE:VZ) They pay 5.3%, 4.1%, 5.3%, 3.8%, and 4.8%, respectively. The tobacco stocks, however, are the only ones truly growing organically. The others are plodding along, but their dividend-paying ability is solid.

I would take a hard look at preferred stocks. These stock-bond hybrids provide terrific stability because their price tends to move in a narrow range while throwing off sizable yields. Those yields can run between 5% and 9%. Because most investors don't understand preferred shares, they haven't run up as much. I like hotel REITs in this space, including Ashford Hospitality Trust (NYSE:AHT) Series D, which yields 8.45% at par. Strategic Hotels and Resorts (NYSE:BEE) Preferred A shares pay 8.51%. Citigroup (NYSE:C) has a Series J that pays 8.24%. JPMorgan Chase (NYSE:JPM) Series J pays 8.18%. You can also grab an ETF with the iShares S&P U.S Preferred Stock Index (NYSEARCA:PFF) that pays 6.02%. I'd also look at the offerings of Public Storage (NYSE:PSA).

Finally, I'd take a good look at Business Development Companies. BDCs provide debt and equity financing to companies with annual revenues of $10 million to $100 million that operate in diverse industries. A BDC seeks to maximize its portfolio's total return by generating current income from debt investments and capital appreciation from equity and equity-related investments, including warrants, convertible securities and other rights to acquire equity securities in a portfolio company. These investments generally range in size from $5 million to $25 million. BDCs look for solid management at established companies with positive cash flow that have a defensible competitive advantage and allow for an exit strategy. They also pay out 90% of their annual tax income each year as a dividend. The trick is an investor must approve of each BDC's due diligence process, as well as their track record of investments.

The companies BDCs finance are those that are growing organically, and growing very quickly. They aren't public companies, so the BDCs give you a way to buy into them.

Prospect Capital (NASDAQ:PSEC) invests in late-stage venture, middle-market, and mature companies. It also gets involved in buyouts and recapitalizations. It pays a monthly dividend (11.3% annual rate). Triangle Capital (NYSE:TCAP) focuses more on leveraged and management buyouts, acquisition financing and growth financing. It pays 8% annually and distributes quarterly. BlackRock Kelso (NASDAQ:BKCC) yields about 9.9% and is one of the premier names in private equity. UBS ETRACS Wells Fargo Business Development Company ETN (NYSEARCA:BDCS) pays about 6.98%.

As with any articles regarding investments, you should never rely on information you read without doing your own due diligence. My articles contain my honest, forthright and carefully considered personal opinion, and conclusions, containing information derived from my own research. This may include discussions with management. I do not repeat "talking points" but may quote management from an interview. I am never influenced by third parties in arriving at my conclusions. Do not solely rely on my articles or anyone else's when making an investment decision. Always contact your financial advisor before investing in any security.

Disclosure: I am/we are long PFF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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