Insights & Advice

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Profit-taking keeps a lid on the markets

 

Sometimes even the stock markets need to pause and catch their breath. This was one of those weeks where the averages, were down, although not by much.

Next week is the Fourth of July and so far none of the warnings that I have been writing about for two months have occurred. May has come and gone. The mid-term election sell-off that has worked in every such year since 1950 flopped as well. The Ukraine, Iraq, higher energy prices and this week a stunning 2.9% decline in first quarter GDP has had absolutely no impact on the stock markets.

In addition, all the technical, momentum, behavioral and fundamental variables that I look at have been flashing red or at least amber for two months, but the markets have simply thumbed their noses at these warning signs. So what, therefore, is an investor to do who has dutifully raised 25-30% cash, which is earning little to nothing?

Two weeks ago, I had mentioned the possibility of putting some of that cash to work in Europe. However, the stock markets over there are still not at a level where I would feel comfortable investing in them. One option I would consider would be parking some of that cash in corporate bonds for now.

Specifically, high yield corporate bonds, commonly known as “Junk bonds,” might be an alternative to that cash. Junk bond funds are yielding between 6-7% right now, which is far better than what you would earn in a money market. Granted, if the markets do correct, junk bonds will go down with the market but not nearly as much.

It’s a hard call to make, because I am still convinced that somewhere out there is a stiff pull-back. The fact that just about every pundit I read has also gave up the ghost and turned bullish leaves me even more cautious. But the markets can remain irrational for far longer than I can stay solvent. So the practical thing to do at this point is put some of that cash back in the market, no matter what happens. Junk bonds are a way to do that and still stay somewhat defensive.

Given my aversion to bonds, some investors may worry that if interest rates rise, as I believe they will at some point, then junk bonds will suffer. Actually, unlike many other classes of bonds, junk bonds occupy a “sweet spot” in the investment world right now. These high yielding bonds are issued by companies that carry a level of risk that is higher than, say, investment grade corporate bonds. As such, companies must offer investors a higher rate of return in order to convince them to buy their bonds.

Junk bonds do best when the economy begins to grow because the chances of these companies failing (and therefore reneging on their interest payments) declines. The stronger the economy, the safer these payments become. So although interest rates rise under those circumstances, the prices of these junk bonds actually go up because of this safety factor. Ultimately, rates will rise to a level that even junk bonds are impacted but that could be 1-2 years away.

Am I hedging my bets here? No question about it. So far I have been wrong, wrong, and double wrong about this pullback. Fortunately, the opportunity cost of doing so has not been great, maybe 2-3% at most, versus the S&P 500 Index. I just don’t want that spread to widen any further by holding too much cash.

 

 

Posted in A Few Dollars More, At the Market