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Stocks have sold off since Federal Reserve chairman Ben Bernanke told the world it would be open season on risky assets as long as he’s in charge—and maybe even beyond.

The Fed’s plan to buy $40 billion worth of mortgage-backed securities a month indefinitely may change investors’ calculus, but it doesn’t change the fact that many asset classes are wildly overvalued. And they all have one thing in common: They’re beneficiaries of a frantic search for yield over the past few years.

Since 2007, investors have dumped $500 billion worth of US stock funds and poured more than $1 trillion into bond funds, even as rates have plummeted and the S&P 500 index has doubled. That has led to much speculation about a “bond bubble.”

If there is one, it hasn’t burst yet. In fact, it just keeps getting bigger and bigger, driving my candidates for the three most overvalued asset classes to even more stratospheric levels. Here they are.

1. Long US Treasury Bonds
This could be the Mother of all Bond Bubbles. Yields plunged from 5.25% in June 2007 to an all-time low near 1.4% in late July, as the global financial crisis and recession pushed the Fed to cut short-term rates near zero and use unconventional measures (so-called “quantitative easing”) to boost the struggling economy.

Bond prices, which move counter to yields, have soared, making ten-year Treasuries an expensive bet right now. But I wouldn’t short them or avoid them completely—remember what happened to PIMCO’s Bill Gross?

In August, long-time bond bull Gary Shilling told me he expects yields on the ten-year to fall to as low as 1%. That would be a big move from the current 1.6%—but remember, he said a new US recession already has started. If you don’t believe that, then the ten-year may not go much below its July lows.

2. Treasury Inflation Protected Securities (TIPS)
These have been popular as a hedge against future inflation. TIPS are Treasuries that adjust their principal and interest based on changes in the Consumer Price Index. When inflation rises, so do semiannual interest payments; they fall when there’s deflation.

The iShares Barclays TIPS Bond ETF (NYSEARCA:TIP) is near its all-time high above 122. That’s a 33% gain since October 2008, when it changed hands at around 92. Vanguard Inflation-Protected Securities fund (VIPSX) has had a similar trajectory.

But when you subtract inflation from the bond’s coupon rate, TIPS now have negative yields—ten-year TIPS sold at -0.75% in the last auction. So, you’re paying the federal government a pretty penny for future inflation protection. And if rates rise, the value of TIPS’ principal will fall, just like any other Treasury.

Bond maven Marilyn Cohen, founder and CEO of Envision Capital Management in Los Angeles and author of Surviving the Bond Bear Market, said TIPS are pricing in “negative yields going out to 2032.” Yet, she adds, “people who have continued to stay in TIPS have done nothing but print money."

I certainly wouldn’t buy new TIPS now, but Cohen said, “If you own it, hold it,” especially if you have a small position (less than 5% of your portfolio).

3. High-Yield Bonds
High-yield bonds have been one of the hottest sectors of the bond market—so hot, in fact, that in May the Vanguard High-Yield Corporate Fund (VWEHX) closed to new investors because of heavy demand.

The Bank of America Merrill Lynch US High Yield Master II Total Return index traded near—sorry to repeat myself—an all-time high, at about 925 this week. That’s a 135% move from around 394 in December 2008. Yields on an index of BB-rated securities have plunged from 16% during the financial crisis to about 5% now.

“At current levels," a B of A Merrill analyst wrote last month, high yield “is standing only 20 [basis points] away from its all-time historical low yield of 6.7%, and its premium price of 102.1 leaves today’s buyers with little hope for price appreciation.”

High-yield bonds have been an incredible investment—the Credit Suisse High Yield Index, reported InvestorPlace.com, “not only provided returns in line with the S&P 500 in the 31-year period from 1980-2011...but it did so with a much lower level of risk (an annual standard deviation of 9.66% compared with 17.49% for the S&P 500).”

Meanwhile, “default risk is low,” Marilyn Cohen pointed out—roughly 2%. “Even though they are overvalued, they’re not too bad,” she said, adding that she thought they could comprise up to 15% of an investor’s portfolio.

There are other worthy candidates for most overvalued. Heather Brilliant, vice-president of global credit and equity research at Morningstar, recently called real estate investment trusts (REITs) “our single-most overvalued sector right now.”

Marilyn Cohen also would put on that list master limited partnerships (MLPs), of which she said “almost all of them are selling at 52-week highs,” and dividend-paying stocks, which she called “the most crowded trade ever.”

All of them have one thing in common—they all yield more than money market funds. “Anything that can generate a modicum of income has gotten overcrowded,” said Cohen. “[Ben Bernanke] wants people to take more risk. Mission accomplished.”

The Fed’s open-ended bond-buying program will probably keep these asset classes from falling back down to earth soon, although the election and the “fiscal cliff” may cause some profit taking in stocks.

But I wouldn’t put new money into areas where there are so many red flags, and I’d keep one eye firmly on the exits. Eventually, what goes up must come down.

Source: The 3 Most Overvalued Assets