"We live on a placid island of ignorance in the midst of black seas of infinity, and it was not meant that we should voyage far. The sciences, each straining in its own direction, have hitherto harmed us little; but some day the piecing together of dissociated knowledge will open up such terrifying vistas of reality, and of our frightful position therein, that we shall either go mad from the revelation or flee from the deadly light into the peace and safety of a new dark age."
- H.P. Lovecraft, The Call Of Cthulhu, Weird Tales, February 1928
Some investors are living on a placid island of ignorance. And nowhere is this more so true today than in the highest yielding areas of the market. Unfortunately, it is in these very same asset classes where income deprived retirees and fixed income earners have been effectively forced to enter as a result of the seemingly endless zero interest rate policies by global central banks including the U.S. Federal Reserve. To this point, they have been harmed little. But I have increasingly grave concerns that the underlying instabilities building under the surface for many of these asset classes will suddenly open up terrifying vistas of reality that will impose major losses on these unsuspecting investors. Unlike the major financial institutions that, despite their ongoing resuscitation from the last crisis, are once again sowing the seeds of another financial trauma through their alarmingly similar misguided actions, who will save the poor masses of individual investors once their frightful position therein is finally revealed? Likely no one. And upon suffering a third major capital market correction since the turn of the millennium, it is possible that many will flee from the deadly light of financial markets for good once this revelation has finally come to pass. As a result, now is not the time for complacency for even the most resilient of investors despite the recent calm across investment markets.
The placidity that has descended upon many asset classes is actually most disquieting, for this remarkable lack of volatility is obscuring the risks that are increasingly building under the surface. The following is an examination of several major asset classes where yield starved investors with low risk tolerances that once relied on the FDIC insured guarantees from their local savings institutions have increasingly congregated in the seemingly endless zero interest rate environment thanks to the U.S. Federal Reserve.
Preferred stocks have been an increasingly favored destination for income seeking investors. By moving down the capital structure, investors are able to secure a higher yield from their investment than if they entered the traditional corporate bond markets. Never mind that many of the investments that commonly reside in the preferred stock category are issued by the major banking institutions that nearly imploded during the financial crisis. For as long as market conditions remain stable and the dividends continue to flow, all is well.
The preferred stock asset class has become so still and quiet in 2014 that it is almost alarming. The category that has historically risen on 56% of all trading days over the last decade has notched gains in a remarkable 67% of all trading days thus far in 2014. Perhaps what is more striking is the complete and total lack of volatility that has come with these gains. While the historical daily standard deviation of returns for the category over the last decade is 1.67%, it has been an almost comatose 0.19% for the category since the start of the year. In other words, preferred stocks as an asset class is quietly drifting higher on under the influence of a steady drip of liquidity being received day after day.
So why exactly is this a problem? Because this is not natural market behavior. An entire asset class should not slowly drift higher essentially day after day without some sign of meaningful reflex at any point along the way. This suggests that forces are at work that are effectively nullifying any natural supply and demand effects that would normally lead to greater deviations in market pricing at any moment in time. While this is all fine and good as long as asset prices are rising under this influence, it raises the critically important question of what happens when this asset class distorting force is suddenly removed either by choice or necessity.
Unfortunately for unsuspecting investors, recent history has shown that it is often a suddenly jarring move to the downside once reality returns. One has to look no further than May of last year when we witnessed such a development for preferred stocks. For the first four and a half months of 2013, preferred stocks as an asset class rose virtually without interruption and with hardly any volatility. But everything suddenly changed in early May and volatility quickly returned with a vengeance. Over the next three months, preferred stocks as an asset class plunged by -9% with wild swings along the way. Fortunately, the category eventually stabilized and regained its footing. But it remains to be seen whether investors will be so fortunate the next time the asset class awakens from its slumber.
In the interest of full disclosure, I have been long the category via the iShares S&P U.S. Preferred Stock Index (NYSEARCA:PFF) since last November. As a result, I have been a direct beneficiary of this upward drifting trend since the start of the year. And while I remain long the category, I fully recognize that on any given trading day conditions may change that will necessitate a swift reevaluation of this position. For while the forces that were quietly elevating the asset class early last year eventually resumed once again to start 2014, there is no telling whether another bounce will happen again the next time a sharp correction takes place, particularly with the Federal Reserve increasingly departing from providing any further daily asset purchase liquidity in the months ahead.
So what other categories other than preferred stocks have been exhibiting similar behavior? Presumably not a coincidence, it has been many related higher yielding areas of the market.
High Yield Bonds (NYSEARCA:HYG) and Senior Loans (NYSEARCA:BKLN) are two prime examples. While both have been exhibiting a bit more daily returns volatility than their preferred stock brethren, it currently is a quarter to a fifth of their historical norms. And just like preferred stocks, both were startled awake from their serenity and entered into a period of violent turbulence last May.
The same can be said even more so of High Yield Municipal Debt (NYSEARCA:HYD). The asset class has performed remarkably well thus far in 2014. In fact, the performance is even better from both a returns and consistency standpoint than what was seen from the category in the early part of 2013. But the asset class suffered a staggering -16% decline last summer from which it is still in the process of working its way back. For those who are retirees and living on fixed incomes, such shocks are unacceptable. For while the category has bounced back, there is no telling how many low risk investors abandoned the asset class either by choice or necessity along the way. And there is no telling whether the category will have the same good fortune to bounce back so quickly following the next sharp and unexpected correction.
Another aspect that is particularly troubling about each of the three categories mentioned here is the following. A business day does not pass without a report somewhere in the financial press from an experienced manager from these areas of the market expressing grave concerns about the fact that the demand for this high yielding paper is so incredibly strong that issuers across the credit quality spectrum including those least worthy borrows are able to freely issue debt with increasingly relaxed restrictions and lighter covenants. As recent history during the financial crisis demonstrated in a big way, these types of behaviors and actions almost never end well. More than anything, it is a question of when such careless actions finally come back to haunt investors yet again. When will policy makers and the institutions that they regulate ever learn? Likely when they are finally forced to truly suffer for the consequences of their actions.
None of this is to say that investors should suddenly abandon these asset classes today. They have worked remarkably well thus far in 2014, and these placid uptrends may continue in the days, weeks and months ahead. As mentioned, I am currently long preferred stocks via the PFF and will likely continue to be long as conditions warrant and the uptrend remains intact. But with all of this being said, those that are invested in these categories should not become complacent but instead should maintain a close watch. For history has repeatedly shown throughout the post crisis period that once this placidity is broken, the subsequent downside can be sharp and violent. And with the Fed finally exiting the daily asset purchase stimulus game seemingly for good, there is no telling whether these categories will be able to recover back into another state of placid bliss the next time around.
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.
Disclosure: I am 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.