People usually associate financial bubbles with greed and investors throwing caution to the wind. Seth Masters sees different dynamics behind a bubble today: fear and investors’ desire for safety. In his recent report, “Desperately Seeking Safety,” the chief investment officer of Bernstein Global Wealth Management argues that the asset classes investors now consider safe havens -- gold, bonds and dividend-paying stocks -- are dangerously overpriced.
Q: How big is what you are calling "the safety bubble?"
A: Over the past five years more than a trillion dollars have flowed out of stocks and into bonds in the U.S. That’s an epical scale of seeking safety. Also, investors felt that actively managed funds were risky, so they moved to index funds. They've felt that within active management, strategies like growth or value were risky and dividend strategies were safer, so they've moved into those investments. In commodities, people moved into precious metals.
We understand the motivation -- 2008 was the single biggest financial crash in living memory. But like any such event, we feel the reaction was excessive. Things people perceive to be safe may not be as safe as they think. Any investment, if you push its price up too much, will have a lousy return.
Q: So there are unperceived risks in playing it too safe?
A: At the end of the day there are two risks investors need to balance. One is the risk of near time loss of capital -- the likelihood that you’ll lose money in a market cycle. The other is that you run out of money.
These risks are in contention with each other. We have a chart showing the probability of either running out of money or suffering a 20 percent loss to your portfolio over 10 years with different asset allocations. If you have 20 percent of your money in stocks and 80 percent in bonds, your probability of suffering a 20 percent loss is less than 2 percent. Your probability of running out of money is 24 percent.
Q: What do you see as the risk to dividend stocks?
A: Many stocks with high dividends don’t have growth potential. Their payout is their primary appeal. Utility stocks, for instance, [are perceived to] have safe dividends. So a lot of people are buying them.
Recently they were trading at a 50 percent premium to their historical average valuation. That’s their biggest premium ever. Most utilities are heavily leveraged, strictly regulated and very sensitive to changing energy costs. That doesn’t sound like a safe investment to me. But people perceive them as safe and are giving up some good returns in other places to buy them.
Q: Where are those other places?
A: In some past market cycles, value has been tilted toward one or two sectors. Right now there are some cheap stocks in every sector. It’s an atypical environment.
Q: Yet you argue that diversified index funds, which have exposure to every sector, pose serious risks.
A: Indexes tend to be overweighted in whatever’s been hot. High-dividend stocks have historically been one-third of the S&P 500 Index. Today they make up 44 percent of that benchmark. We don’t know when the correction in them will be, but it seems to us it will be significant. Meanwhile, many other companies that have been buying back shares instead of paying dividends haven’t been doing so well.
Q: Couldn’t you just buy a high-growth index fund or a deep-value one that ignored most of the overpriced dividend stocks?
A: You have a point, but the broad-based flight to safety has polluted every sub-style of investing. To the extent that an investor bought a value index fund they might get less exposure. There would still be companies in the index perceived to be safe, and those would be overweighted most.
Q: What about gold?
A: Gold prices have been weak for the past few months, but it is also part of the safety bubble. The math to prove this is fairly simple. The least efficient gold producers can currently produce an ounce of gold for about $800. The fact that gold now trades for about twice that cost shows there’s a lot of precautionary demand in the market. The fundamental value is $800, but people are buying it because they’re scared.
Q: You mentioned companies buying back stock. Are they attractive?
A: Just because a company is buying back stock doesn’t automatically make it good. It’s fair to say that for people with high incomes, the benefits of stock buybacks as opposed to dividends just got greater. That’s because tax rates on dividends for wealthy investors just went up this year, from 15 percent to 20 percent. That means on a relative basis, buybacks that don’t cause any taxable income to be distributed are now more attractive.
(Lewis Braham is a freelance writer based in Pittsburgh.)
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