Is there such a thing as too much money?
This is not a question addressed to you, or me, personally. We have yet to experience this problem. We may be well-off, well-heeled, well-to-do or well-fixed, but we’re not awash in money.
So it’s difficult to understand a world that is.
It isn’t easy to prepare for the consequences, either.
But some of the best people in the investment business are suggesting just that— too much money is chasing small opportunities with big risks. One warning comes from Steve Leuthold, a portfolio strategist frequently mentioned in this column. Mr. Leuthold is taking most of his chips off the table.
Some will dismiss him because he was embarrassingly early (read years) on his call for caution before the 2000-2002 wipeout. So let’s listen to another voice, Bill Gross.
Mr. Gross, master of the bond universe at PIMCO, writes a monthly commentary on the firm’s website, www.pimco.com. The heart of his April note was that so much money, much of it in hedge funds, is chasing so few opportunities that entire sectors of the global bond market aren’t worth investing in. Money managers and individuals, alike, are investing as though risk did not exist.
But the figures that really got my attention came from James Montier, director of global strategy at Dresdner Kleinwort Watterstein, based in London and Frankfurt. You can read Mr. Montier’s comments, “The Dash to Trash,” in John Mauldin’s newsletter Outside the Box. Ironically, Mr. Mauldin’s newsletter originates from his office at the Rangers’ ballpark in Arlington, Texas. It’s a good read, and he’s a great “idea scout” (see URLs below). Here are some of Mr. Montier’s key observations:
- Although Nasdaq stocks are trading at 40 times trailing earnings, short interest— the number of shares sold short in hope of buying back later at a lower price— is only one and a half days’ volume of the Nasdaq exchange traded fund (ticker: QQQQ). This is a nosebleed-high multiple of earnings, and few see any risk.
- Trashy stocks are the ones investors are buying. Globally, stocks with high dividends have underperformed stocks with low dividends so far this year by 0.8 percent. In the United States the gap is 1.8 percent, and in Europe it’s 3.5 percent. Similarly, stocks with high earnings stability are underperforming relative to stocks with low earnings stability.
- Trash prevails, year-to-date, when stocks are ranked by their Standard & Poor’s quality rating. Montier reports that stocks ranked A-plus by S&P have returned less than 5 percent year to date, while stocks ranked C, the lowest rank before succumbing to reorganization or liquidation, have returned over 16 percent year to date.
- Investors are paying a premium for junk, Montier notes. While the A-plus ranked stocks have historically sold at an average forward P/E ratio (multiple of expected earnings) of 16.7, they are now selling at 14.6. The opposite is happening with lower-quality stocks. Stocks ranked B-minus by S&P historically sold at an average forward P/E of 14.9 but today are selling at 18.0 times predicted earnings. As a consequence, high-quality stocks are relatively cheap. Investors seem to have forgotten the pain of 2000-2002.
Meanwhile, simple, no-risk fixed-income investing is looming large as a competitor for stock investing. But no one cares. Recently, for instance, 5-year Treasury notes were priced to yield 4.95 percent, and 5-year Treasury Inflation Protected Securities (TIPS) were priced to yield 2.29 percent over the rate of inflation. With a trailing inflation rate of 3.4 percent, that means 5-year TIPS may now be providing a yield of 5.69 percent. The yield could be higher if the inflation rate over the next 5 years is greater than 3.4 percent. I think that’s a really good bet.
Viewed in terms of earnings yield (stock earnings per share divided by price), low-quality stocks at 18 times uncertain forward earnings have an earnings yield of 5.56 percent, slightly less than the earnings yield on 5-year TIPS. High quality stocks, meanwhile, have an earnings yield of 6.85 percent, only a small premium over no-risk Treasury obligations.
What’s the bottom line?
The year 2006 is developing a really creepy resemblance to 1987. That’s when both interest rates and stocks rose— until October, when stocks plunged 20 percent in two days.
On the web:
James Montier, as featured in John Mauldin’s “Outside the Box” http://futures.fxstreet.com/Futures/content/101960/content.asp?menu=review
William Gross April 2006 comment http://www.pimco.com/LeftNav/Late+Breaking+Commentary/IO/2006/IO+April+2006.htm
The latest on the Consumer Price Index: http://www.bls.gov/cpi/
Bloomberg fixed income returns: http://www.bloomberg.com/markets/rates/index.html
This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
Photo by Suzy Hazelwood from Pexels
(c) A. M. Universal, 2006