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Clif Droke

Clif Droke

Clif Droke is the editor of the two times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock…

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The Yield Trap

Providing the fundamental backdrop for the latest immediate-term broad market top are two important considerations, one of which we hear no end of in the financial press. The other one, strangely, has been given much less attention than would normally be the case. Of course I'm referring to oil and the yield on the 10-year note.

The predicted parabolic rally in the 10-year Treasury Yield Index (TNX) has transpired since we last looked at interest rates. The exhaustion of the previous short-term decline was discussed in the Feb. 11 commentary as a short-term buy signal was flashed by the "channel buster" referenced previously.

Coming off its floor at the 4% area the yield on the 10-year note has rallied in near-vertical fashion up to 4.57%, a sizeable jump in percentage terms in only a few weeks. This is not surprising given for how many weeks the yield on the 10-year note was held down against the recent imbalance of the yield curve. The "Rule of Alternation" has come into play here, among other things. TNX has now made a yearly high and has broken out of its 6-month lateral trading range.

This will spell trouble for equities as the year wears on if rates are still on the up-and-up. Too many analysts based their rosy prognostications for the year ahead on the assumption that interest rates would remain low or even go lower. They will slowly wake up to this erroneous assumption before long. In fact, early indications show the awakening process is already underway: The London Financial Times recently quoted George Bory, credit analyst at UBS, who observed, "It is the first time a sense of uncertainty has crept into the market in a very long time. Investors are re-evaluating their positions after a sharp rise in Treasury yields." Check out the chart below to get an idea of just how far off the benchmark lows the yield has traveled.

Now let's shift gears for a moment and discuss another aspect of yields as it pertains to stocks. Stock yields are a device often used to lure investors with large sums of cash on the sidelines back into the market, enticing them to buy stocks after a decline when the yields on those stocks start to rise. But is this practice of seeking dividend-yielding stocks always a wise investment practice?

In recent weeks there a rash of newspaper and magazine articles in the financial press have appeared extolling the virtues of dividend stocks. A recent Business Week commentary was entitled "Still Sweet on Dividend Stocks" and discussed the "bountiful returns" of dividend-paying stocks, touting them as alternatives to AAA-rated municipal bonds. The article asks, "What have your bonds done for you lately?"

Dividends are also increasingly being used as carrots in corporate takeover bids. An article appeared in the Feb. 28 Business Week under the headline "Will dividends drive a slew of new deals?" It explains how the $6.7 billion deal between Verizon Communications and MCI is being used to placate investors by using dividends as an incentive. According to Business Week, MCI shareholders would receive 1.4 billion in dividends before Verizon ponies up $5.3 billion of the $6.7 billion deal. (It should be noted that one skeptic of the deal said the cash payouts "amount to nothing more than handing back to MCI shareholders their own money.")

While looking at stock yields can often be an excellent indicator for finding short-term bottoms, especially after a steep decline, it can be quite dangerous to buy-and-hold a stock for the intermediate-to-longer-term based on a high or rising yield. This is what my good friend Samuel Kress calls "the yield trap."

As Kress has said, when a stock has been in decline due to poor fundamentals or a bad industry outlook and after a time the yield on the stock begins to rise, it can become attractive to investors and "suck them in just before the wagon wheels are about to come off" as Kress puts it. While a rising yield often presages a short-term rally, the investors who buy at the first signs of increasing stock yields often end up "holding the bag" as the yield eventually collapses and price resumes its downward path.

Yields have come back into vogue on Wall Street in recent months as investors look for the perceived safety of dividend paying equities. Increased market volatility means more investors will become yield-conscious and thus the trap can be set for these unsuspecting investors who simply buy and forget, not bothering to look at their stock's performance on a regular basis. By the time they notice those wagon wheels have come off, it's too late!

Another aspect of the yield trap is found in the speculative arena of "high yield bonds," a.k.a. "junk bonds." In "normal" times, the junk bond yield can be as high as 5% to 7% higher than U.S. Treasury bonds, which is to compensate for the higher risk. "However," comments Bert Dohmen in a recent Wellington Letter (www.dohmencapital.com), "At the bear market low of junk bonds in 2002, when gloom and doom was the thickest, money was looking for safety. Therefore, the yield spread was a hefty 10 percentage points. It took such high yields to attract investors."

Dohmen points out that the current yield spread between junk and Treasuries is around 2.6 percentage points, the narrowest spread in 14 years. "In other words," he says, "complacency and bullishness about the economy, the credit markets, and investment markets is extremely high."

He adds that it is precisely at such times when bullish complacency and euphoria are high that the unexpected usually happens. He references 1998, the last period of junk bond euphoria, when the Asian currency and Russian credit crises began. This was followed by a plunge in junk bonds and brief but severe decline in stocks.

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