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June 13, 2007

Remain Calm! Its Only a Bunch of Bear Markets
by Brady Willett

"A measure of utility companies lost 1.5 percent for the second steepest decline among 10 industries in the S&P 500. Collectively the stocks have a dividend yield of 3.05 percent, the most in the index. Higher bond yields make their dividends less attractive." Bloomberg

The guaranteed yield on the 1-year Treasury bond broke above 5% yesterday and ? suddenly? ? a risky dividend yield of 3.05% becomes 'less attractive'? Why were the lowly yields on utilities, which are the highest of any S&P group, not 'unattractive' a couple of months ago or even last year?

Don't get me wrong, after a period of widespread destruction and management changes in 2002-2003, many utilities have become more focused; balance sheets have generally been purged of debt as non-core business units have been shed. Combine this with declining interest expenses and the expectation is that dividend payouts could grow at an above average clip should the growth fundamentals for utilities continue to be agreeable.

But alas, the one fundamental many market participants seem to have forgotten is that companies, utilities or other, have not discovered a secret formula to combat recessions and/or bear markets. Rather, those investors that believe 3.05% provides any degree of security during bad times are likely to prove, at the minimum, to be naïve. As for the ludicrous bull market analysis of equity/bond yields, it distracts from common sense: during the last bear market in stocks interest rates were crashing lower and dividend yields on stocks were rising, and on an absolute basis no one in their right mind is going to chase a 3.05% div stock during the next bear.

At the risk of rambling, allow one factoid to settle: other things being equal in order for the yield on utilities to equal the yield on the 10-year Treasury bond utilities would have to fall by 42% from current levels.

What About Those Rising Interest Rates?

With some ominous trends highlighted, here are a couple of different extreme scenarios to think about going forward:

#1. Bond bear. Under this scenario interest rates continue to rise as central bankers mindlessly print money at a faster clip than the destruction rising interest rates unleash in the financial markets. Some gold bugs and bears are keying on this scenario (apparently because it brings back fond memories of the late 1970s). However, even with Helicopter Ben in charge it is difficult to believe that the Fed will accept lethal amounts of inflation instead of recession. Put simply, the destruction that would ensue if U.S. interest rates rise significantly higher from current levels, particular in the U.S. housing market, is almost unimaginable.

The question bond bears need to ask is whether or not U.S. interest rates have stopped being the rudder for the global economy. You have to believe that they have if you buy into the idea that a secular bond bear is in the making.

#2 Bond bull. Rising interest rates will hit the global economy and/or continue undercut the financial markets (which would eventually impact the global economy), and when risky assets start falling guaranteed investments like U.S. Treasuries will attract money. As a quick example of how this scenario plays out, remember that the last time - before yesterday ? the yield on the 1-year Treasury bond was above 5% was on February 26, 2007. On February 27 the equity markets got rocked and money started moving into bonds.

After a prolonged period of declining interest rates, and with central banks seemingly united in their pursuit to debase paper, calls for a 'bond bull' may be wishful thinking. How about bullish safe haven bursts from time to time into bonds with no lasting up/downtrend in interest rates?

Conclusions Without The Hyper

It is entirely possible that as quickly as the 'bond bear' threat has reappeared an unexpected blow-up in the markets will transpire to make this threat disappear. If such a change in investor focus can happen in a semi-orderly manner there is also the possibility that some of the excessively large piles of liquidity in the financial markets can be salvaged. With that said, it is highly unlikely that all asset classes will exit the immediate inflation/interest rate threat unscathed. For a brief while - and on a global basis - stocks, bonds, real estate, and commodities all attended the same party, but it increasingly looks like this party has unceremonious come to an end. The only question is which partygoer(s) are about to leave the party...

Incidentally, with deflation the one threat not on the horizon, the other very extreme scenario to consider is that of hyperinflation. While a deeply statistical journey into U.S. government finances are enough to give any historian nightmares, the reality is that the global economy must assert its independence from the United States before the possibility of hyperinflation comes into view. And although this shift is indeed underway, the rest of the world is still not even close to being ready to run out the dollar. For that matter, the most important in/stag/hyper-inflation monitor around ? gold - isn't suggesting any hyperinflation threat (as for the contention that gold is (still) being manipulated by central banks, ironically this is akin to agreeing that fiat backed inflation is still under control).

In short, as painful as a bear market in some or all of the four assets classes listed above might seem, it is nothing compared to the hell that will be unleashed when the world finally kicks its dollar habit. On the plus side, even U.S. dollar denominated utility stocks would be worth the risk if prices decline by 42%.

Brady Willett
FallStreet.com

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