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Making Money from the Macro

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8

September 29, 2011 – Comments (0)

Board: Macro Economics

Author: PosFCF

 

Some thoughts......

Assumptions:

1). The Fed is successful in their policy of keeping longer term yields low.

2). Lackluster US economy for years ahead.

3). Ongoing European debt problems.

4). Focus of this thinking is on equities versus cash.

5). Equities under consideration are all US based.

The issue addressed in this post:

"How does a conservative investor position their assets given the above assumptions?"

For me, what I had to do first was to understand the drivers of the conservative investor psychology. I have made two assumptions in framing that psychology:

a) Preservation of principal is more important than return on principal.

b) Just preservation of principal will not provide enough assurance that the individual won't outlive their money.....otherwise why have the money in the markets at all?

So...where that led me.....

If Treasury yields are going to be in the vicinity of 2% for the 10 year product, what relatively safe dividend payers might they obtain & what is the likely performance of the price of the shares of those companies going forward?

To answer the second part of that question is what prompted this post.

It seems to me that utility companies and some companies in the energy space (like pipeline companies), offer dividends in the range of 2% to 12%.

It also seems to me that often the yields on debt instruments are priced to yield somewhat more than Treasuries. Theoretically this is because Treasuries are assumed to be "risk-free" whereas everyone else is presumed to at least have business risk.

I think many more today have doubts about the "risk-free" assumption of Government debt instruments (including US ones) than ever before, but that is a different discussion.

So, suppose I buy a utility company yielding 5%? This is an entity that is regulated by the State government(s) in which it does business and part of that regulation is a guaranteed profit. So, if the company starts losing money, they go to the regulating agency, make their case before the board, and get price increases sufficient to make their costs plus a small profit again. That seems to be a pretty safe model from a lot of aspects.

In a 2% Treasury world, that 5% looks pretty good.

I'm thinking that a lot of people are going to come to that awareness and, as they do, the price of the shares of the utility will rise until the yield at the new price is about as high above Treasury yields, relatively, as their corresponding brothers in the debt world.

In other words, if in the debt market, a good quality paper is selling such that it yields a 3% yield as opposed to the Treasury's 2%, then in the safer part of the equity world, dividend yields will also become priced such that they yield a similar relative difference.

So, the price of the 5% yielder in my example would need to rise such that it now would yield 3%. Let's take a hypothetical example: Suppose XYZ utility is paying $1.00/yr dividend and is selling for $20.00/share which makes the yield 5% ($1/$20). If my theory is correct, as more people try to capture a better yield than Treasuries, the price of XYZ will increase to about $33 thus driving the yield of that $1.00/share dividend down to the 3% range.

Obviously, there are safety factors and risk factors which will not likely see a current 12% yielding enterprise's price rise to where it will be yielding 3%, but it might rise under this set of forces to a point where it only yields 6% or 7%.

Anyway, the offshoot for me has been to try to find some relatively solid, nice dividend paying companies which have the likelihood of still performing their business functions well given the assumption of a lackluster US economy going forward. The companies that seem to fall into the parameters I've established seem to be utility companies, pipeline companies and, oddly enough, some of the big pharmaceuticals.

Ideas welcome as long as they are civilly presented.

Poz

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