Fed Saying It May Remove 'Training Wheels' Is No Reason To Panic

by: Steven Bavaria

When remembering the roller coaster ride of five years ago, it is easy for some investors to get scared when the market drops, as it has in recent weeks. But unlike the "great meltdown" of 2007-2008, the current market drop is a reflection of strength in the economy and the markets, not weakness. It's a momentary panic, like when you tell your child they are doing so well learning to ride their bicycle that pretty soon you can take their training wheels off. Your child may panic for an instant at the thought of no training wheels, but the underlying reality is the positive story that they are making progress.

The current market swoon reflects the realization that the Fed's "training wheels" - quantitative easing - will eventually taper off and even have to be reversed, thus removing a major support for the equity and debt markets. That's the traditional "removal of the punch bowl" by the Fed as economies strengthen, and it is the major thing spooking the markets. Fed Chairman Bernanke's totally reasonable and predictable comments that the high powered punchbowl - the bond buying program - will run down and be removed over the next year or so, but that interest rate levels will continue to stay low even longer (perhaps 1915) until unemployment improves further, doesn't sound too scary to me. What would be scarier would be the suggestion that the economy were not improving enough for this to start to happen.

There is an additional reason to be optimistic about stocks. All the money in bonds is not going to stay there once it becomes obvious that the economy is improving and the punchbowl is actually being removed. Too many investors who have been in bonds as a short term investment or speculation know that once the stimulus is gone for good and the Fed begins tightening, interest rates can only increase and bond prices can only drop. When that finally happens (whether it's gradual or a sudden rush for the exits) certainly a portion of that money previously in fixed rate bonds will head into equities, providing a strong secular push to the upside. And if economic fundamentals (and therefore corporate profits) continue to improve, even if only slowly, then such a rally should be sustainable.

So what should an investor do?

Anyone who reads my articles (here and here) knows what I'm about to recommend. If you are a long-term investor who views your investment portfolio as a source of future income (for retirement, sending kids to college, etc.) then this is like a sale on income-producing assets.

Here's my personal experience in recent weeks. Like many readers and contributors to Seeking Alpha, I had a great run from the end of 2012 until early in May, with my portfolio up almost 14%. Since then I've lost just over half of that as the market dropped. But the income on my portfolio - which is what I really care about and track closely - hasn't dropped at all. In fact, it has increased during this period as I have shifted and rebalanced, especially on the most volatile days, often selling a security that for whatever reason had NOT dropped much on that day and using the proceeds to buy one of my existing or "approved list" securities that had dropped.

As a result partly of the rebalancing and mostly due to the overall drop in prices, my re-investment rate for dividends is now 63 basis points (i.e. 0.63%) higher than it was at the beginning of May, when my portfolio's market value peaked. That means all the dividends that I receive (and I only buy high income yielding stocks or funds; mostly closed end funds lately) can be re-invested and compounded into the future at that higher rate. I am actually hoping that the market doesn't recover for at least the next few weeks, since the second-quarter end-of-June is a popular dividend-paying time and I hope to reinvest in my favorites (listed below) while they are still on sale:

Name, Yield/Distribution, and Discount (for Closed End Funds)

  • BlackRock Global Opportunities Equity (NYSE:BOE) 9.27% -11.28%
  • BlackRock Utility & Infrastructure (NYSE:BUI) 8.16% -7.5%
  • Duff & Phelps Global Utility Income (NYSE:DPG) 7.92% -8.73%
  • Enbridge Energy Management (NYSE:EEQ) 7.48% NA
  • Eaton Vance Enhanced Equity Income (NYSE:EOI) 9.06% -11.03%
  • Eaton Vance Risk Mgd Diversified Eq. Inc. (NYSE:ETJ) 10.26% -9.78%
  • Eaton Vance Tax Mgd Buy Write Opps. (NYSE:ETV) 10.34% -7.35%%
  • Eaton Vance Tax Mgd Global Buy Write (NYSE:ETW) 10.58% -8.61%
  • Eaton Vance Tax Mgd Global Diversified (NYSE:EXG) 10.58% -8.26%
  • Cohen & Steers Closed End Oppty (NYSE:FOF) 8.13% -5.26%
  • ING Risk Managed Natural Resources (NYSE:IRR) 10.79% -8.87%
  • Nuveen Equity Premium Advantage (JLA) 9.36% -9.54%
  • Oxford Lane Capital Corp. (NASDAQ:OXLC) 13.94% -2.59%
  • Royal Dutch Shell (NYSE:B) Shares (NYSE:RDS.B) 5.42%
  • Seadrill (NYSE:SDRL) 8.74% NA
  • AT&T (NYSE:T) 5.24% NA
  • Third Avenue Focused Credit Fund (MUTF:TFCIX) 7.27% NA
  • Cohen & Steers Infrastructure Fund (NYSE:UTF) 7.66% -8.65%
  • Reaves Utility Income Fund (NYSEMKT:UTG) 6.54% -4.33%

I see this as a high yielding but defensive portfolio. The Eaton Vance funds (Eaton Vance Enhanced Equity Income , Eaton Vance Risk Mgd Diversified Eq. Inc. , Eaton Vance Tax Mgd Buy Write Opportunity , Eaton Vance Tax Managed Global Buy Write, Eaton Vance Tax Mgd Global Diversified and the Nuveen Equity Premium Advantage Fund are all non-leveraged, option-income funds, which makes them defensive to begin with, but in addition selling attractive price discounts offering further downside protection. Likewise, BlackRock Global Opportunities Equity and BlackRock Utility & Infrastructure, both of which employ option-income strategies and are highly discounted.

BlackRock Utility & Infrastructure has the added advantage of being a utility and infrastructure fund, a sector I like as an all-weather long-term "keeper" of an investment category, and which has served me well through all kinds of markets. Other funds in this category are Cohen & Steers Infrastructure Fund, Reaves Utility Income Fund, and Duff & Phelps Global Utility Income. All are good buys at current prices for long-term holders.

Oxford Lane Capital and Third Avenue Focused Credit Fund (TFCIX) are funds I have written about before (see previously cited article). They offer equity-like returns without the volatility of stocks, having essentially replaced equity risk with credit risk. My experience after 40 years in the banking and credit markets is that credit, while still risky, is less volatile and easier to model and predict than equity risk. So hedging your portfolio with credit risk (NOT interest rate risk, as in most bond portfolios) makes some sense. The non-funds mentioned - Seadrill , Royal Dutch Shell and AT&T - are all solid long-term dividend growth stocks available on sale this week at attractive entry points.

Disclosure: I am long BOE, BUI, DPG, EEQ, EOI, ETJ, ETV, ETW, EXG, FOF, IRR, JLA, OXLC, SDRL, T, UTF, UTG, RDS.B. 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.

Additional disclosure: I am also long Third Avenue Focused Credit Fund (TFCIX).