A Second Nip From A Double Dip – The AIA Advocate Newsletter Week of 8/26/2010

In This Issue:

A Second Nip From A Double Dip
Bonds Are Soaring, But Could Be A Bubble
Blue Chip Discounts May Not Last Long
Two Bond Substitutes Look Especially Good
True Cash Returns Are Higher Than They Appear
The Bottom Line

Since our last newsletter in July, the economy signaled that it may not be doing as well as it was earlier in the year. The employment rate is failing to improve, consumer confidence is slipping, retailers are singing the blues, many manufacturers are reporting fewer orders, and July home sales plunged a disturbing 27%.

As a result, many analysts are beginning to think the economy may be heading for another leg down – the dreaded “double dip.” If so, many stock prices have been pushed too high. Accordingly, investors have been pressing Wall Street’s down button of late. Since July 29, the Dow and the Nasdaq declined 3.9% and 4.9% respectively.

A Second Nip From A Double Dip

Even if the economy does have a second dip on the way, there is a big difference between pushing growth into the slow lane and pushing it off the road. As long as the economy remains in the black, the most efficient American companies can continue to grow their profits.

Companies that do a lot of business in the strong global economy can do even better. Everything from bulldozers to computer chips is selling well. That happy situation should continue at least through the balance of the year, which is about as far ahead as anyone can see at this time.

The bottom line is, we expect the stock prices of America's top companies to move up this fall.

Bonds Are Soaring, But Could Be A Bubble

We once heard a story about an old sea captain who started each day by opening a locked drawer and reading a short note. One day curiosity got the better of the first mate who picked the lock and read the note. It said...

“Right is starboard, left is port.”

Investors can also need reminders about routine matters. An example is the relationship between interest rates, prices, and yields for bonds. That’s important right now because the bond market is heating up. In fact, it is positively sizzling.

When interest rates go down, as they are doing now, the price of existing bonds go up because they pay higher rates. However, as prices rise, the effective interest rate –referred to as the yield— will decline.

For example, a $1,000 bond with a 5% interest rate will pay $50 a year until it matures and the principal is returned. If interest rates drop sharply after the bond is issued, an investor may pay $1,050 in the secondary market to get the 5% bond. But if the bond’s price rises that much, its yield will fall to 4.76%. That’s because the person who buys the bond for $1,050 will only get the same $50 payout as the person who paid $1,000.

On the other hand, if interest rates go up, the price of existing bonds will fall and their yields will go up. The higher interest rates go, the lower the prices – and therein lies the problem.

Right now, the yield on a 10-year Treasury Bond is a miniscule 2.62%. Nevertheless, many nervous investors are buying them by the bushel. If the U.S. economy gets a whiff of inflation and interest rates start to rise, the price of the bonds will decline. If interest rates rise to 4%, which is where they were just a year ago, people who own the bonds will have a capital loss that could be three times the current yield. Since we think inflation is likely to show up sometime during the next 10 years, bonds appear very risky to us.

Of course, people don’t need to sell bonds that have fallen in price. They can hold the bonds until they mature and get all their principal back. But if inflation occurs during that time, the dollars they get back will have less purchasing power than they did originally. In other words, the bond holder will still lose.

Blue Chip Discounts May Not Last Long

Bonds have their place in a diversified portfolio, but blue chip stocks perform much better over the long term. That’s largely because the world’s best companies are almost always able to increase their profits over time, whereas the interest rates on most bonds are fixed.

Fortunately, with all the economic and stock market worries we have today, many top quality blue chips are selling for unusually attractive prices. As we said last month, the dividend yields that many of them offer are higher than most bonds are paying now. Since the best blue chip stocks also offer good prospects for long term capital gains, we think they are more attractive than fixed income securities.

Investors who are interested in buying any of the better blue chip stocks should probably make their move soon. Over the past few years, much of the money that would have ordinarily gone into the big multinationals went into hedge funds, private equity deals, commodities, and a variety of Wall Street’s derivative shell games. Now that the bloom is off those roses, money is starting to come back to America's top stocks. If the trend continues apace, the blue chip sale may soon be over.

Two Bond Substitutes Look Especially Good

In addition to the blue chip stocks we recommended last month, we like the outlook for a leading utility company and an exchange traded limited partnership. We discussed both of them in January 2009, but they are even more attractive in today’s lower interest rate environment.

Kinder Morgan Energy Partners LP (KMP) is the largest independent owner/operator of oil and gas pipelines in the country. http://finance.yahoo.com/q/bc?s=KMP It is a solid business that isn't very susceptible to changing fuel prices. Whatever energy happens to cost, it still needs to be moved from where it is processed to where it is used.

Although Kinder Morgan trades like a stock on the NYSE, it is actually a limited partnership that distributes its available cash to investors each quarter. Currently, the yield is an outstanding 6.4%, which is over twice the yield on 10-year Treasury bonds. Best of all, only part of the payout is taxable.

Consolidated Edison (ED) is also a winner. http://finance.yahoo.com/q/bc?s=ED Con Ed supplies electric power, natural gas, and steam to a total of over 4 million customers in New York, Pennsylvania, and New Jersey. The company also sells power to other utilities in the Mid-Atlantic region.

There aren’t many American utilities with a longer history of success than Con Ed. It was founded in 1884 when Thomas Edison proved that electric networks were feasible. More importantly to investors who seek income, the company raised its dividends 35 years in a row. That’s an outstanding track record. The yield is currently an attractive 5.1%.

If you wish broader diversification within the top-paying blue chips, we continue to recommend the iShares Dow Jones Select Dividend Index (DVY).

http://finance.yahoo.com/q/bc?s=DVY&t=1y This ETF tracks the 100 highest-yielding securities (excluding REITs) in the Dow Jones U.S Total Market Index. The fund is ideally positioned to benefit from the world’s growing preference for large, stable, dividend stocks.

True Cash Returns Are Higher Than They Appear

People who recently put money in deposit accounts or fixed income securities are less than thrilled with the low returns they are receiving. Interest rates are on the floor. For many retired people, the abysmal payouts are creating real hardships.

But there is another side to the low interest rate picture that is getting little notice. Rates are low because inflation is also on the floor. In fact, the price of many goods and services are actually dropping for the first time in years. Even energy and some food costs are declining. That means cash is going further than it did previously, and the gain represents a real return on your money.

For example, cash left in a money market account for a year may earn only 1%. Towards the end of the year, however, you may use the cash to buy something you need. If you get a 30% discount because you have cash available during this tough recession, it represents an additional return. As a result, the effective gain on your cash will be 31%.

The Bottom Line

The declining economic outlook has been casting a pall over the stock market of late. Although no one seems to be in a panic to sell, the major indices have been slipping all month.

The pessimism is even extending to the price of many companies that are doing very well. We think investors should use the opportunity to buy more of the world-class blue chip stocks that we have been recommending in recent months.

Unlike the stock market, bonds are on a tear. Frankly, we think the bond market is forming a bubble that will pop at the first sign that interest rates are about to rise. Blue chip stocks that pay attractive dividends seem like a better way to get current income plus a real prospect for long-term capital gains.

Until Next Time

The AIA "Advocate For Absolute Returns", a publication of The Association for Investor Awareness, Inc., tracks market trends, industry news, the SEC, global trade and finance and Washington developments for you because they affect your investments. But who doesn't? Many sources report these issues as abstract facts. We feel that's not enough. The AIA Advocate's job is to warn you of what's important and how these developments translate to ground-level forces and threats that directly affect your wealth as well as your current investment opportunities. Not just information, but information you can use. Until next time.…


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Posted 08-26-2010 3:26 PM by Research & Editorial Staff