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Portfolio > Mutual Funds > Bond Funds

Bernanke wants you to buy stocks, but risk is high

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Ben Bernanke hopes his latest plan to stimulate the economy will get you to buy stocks and other risky assets. Maybe you should. People who did that after two similar Federal Reserve efforts are sitting on big gains today.

But the odds of fat profits aren’t looking as good this time, and seem to be getting worse.

Stocks rose sharply before the Fed chairman announced his plans Sept. 13 instead of falling, as they did before the two previous efforts, suggesting less room for gains now.

Meanwhile, the world economy is slowing and Wall Street analysts are cutting estimates for future corporate profits. They expect them to fall this quarter from a year earlier, the first drop since just after the Great Recession ended 3½ years ago.

See also: 3 fiscal storms brewing

“The market seems like it’s climbing on central bank intervention rather than fundamentals,” says Gary Flam, chief stock manager at Bel Air Investment Advisors. “I’m not a buyer right now.”

The outlook for other risky assets like high-yield bonds is darkening, too.

The highly indebted companies that issue these bonds, popularly known as junk bonds, usually offer fat interest payments to compensate investors for the risk that the companies will default.

Not now. In response to previous Fed stimulus plans, investors have poured money into these bonds, driving prices up and yields, which move in the opposite direction, down to 6 percent, the lowest on record. In the boom years before the recession, the lowest yield was more than two points higher.

“We have a high-yield bond market without yield, and the Fed’s fingerprints are on this,” says James Grant, editor of the newsletter Grant’s Interest Rate Observer. “If debt prices turn out grossly overvalued, won’t it owe an explanation for people who lost money?”

Earlier this month, the Fed chairman said the central bank would spend $40 billion each month buying mortgage bonds until the economy strengthens, and maybe even after. In its two previous programs, called quantitative easing, the Fed bought $2 trillion worth of Treasury and mortgage bonds.

The idea is to frustrate holders of conservative assets, like Treasurys, so they’ll have no choice but to shift money into riskier fare. As they do, prices will rise, making people richer and willing to spend more money. And that, at least in theory, will speed economic growth.

Some critics argue the Fed has failed, noting that the U.S. economy grew at just 1.7 percent annual rate in the April-June quarter. But you can’t deny it’s been successful at least in part: People have moved money into riskier assets, and prices have jumped.

Since the Federal Reserve launched its first bond-buying program in November 2008, high-yield bonds have gained 68 percent, or 14.5 percent annually, 1.5 times their typical return, according to Martin Fridson of FridsonVision, a high-yield research firm. Meanwhile, the Standard & Poor’s 500 index, in price alone, has gained 85 percent.

In 2012, the S&P 500 has risen 16 percent, almost all of it since June in anticipation of the Fed’s new stimulus.

It’s possible stocks will continue to climb. The S&P 500 is trading at 14 times its expected per-share earnings for the next 12 months, which doesn’t appear expensive. This earnings multiple was lower — meaning stocks were cheaper — at the start of the first Fed stimulus, in November 2008, but only slightly: It was 12.9, according to S&P Capital IQ, a research firm. At the start of the Fed’s second round of bond-buying, in November 2010, the S&P traded at 14 times, the same as today.

But stocks seemed just as expensive then as they do now because expectations for earnings then were low. Since the recovery began, Wall Street analysts have mostly been scrambling to raise their expectations, not cutting them, as they are now. They were surprised how much companies were able to sell abroad, slash expenses and get more work out of smaller staffs.

Last year, companies in the S&P 500 squeezed a record $8.80 in profit out of every $100 in sales, up from $5.90 after the first Fed program, according to Goldman Sachs. But now these profit margins are falling for the first time in the recovery, and revenue growth is dropping as Europe slips into recession and many developing countries slow.

See also: The fallout from Europe

And the bad news keeps coming. On Tuesday, FedEx, considered a bellwether because its shipping operations span the globe, said that trading volumes had slowed to recession levels. On Thursday, railroad giant Norfolk Southern dropped 9 percent after reporting a steep fall in shipments.

If the economy continues to slow, or falls into a recession, investors in high-yield bonds will get hurt, too. They appear to be reassured by the low number of bonds defaulting now, about 3 percent. But defaults could rise fast. In 2008, defaults peaked at 13 percent, clobbering investors in high-yield. Investors in mutual funds holding so-called junk lost 26 percent that year, according to Morningstar, a fund tracker.

“If you need income, you don’t have much choice but to go to riskier assets,” says Fridson, the junk bond expert. But he adds, “If the country falls back into recession, people will face losses.”

Should junk tumble, Grant, the newsletter editor, quips that Bernanke should consider a “handwritten apology” to investors or possibly a spoken one on “60 Minutes.” But he holds out the possibility prices will continue to rise, noting that the Fed’s efforts to stimulate the economy, as well as similar bond-buying plans by central banks in Europe and Japan, are unprecedented.

“One can’t be dogmatic about likely outcomes of an untried, worldwide experiment,” Grant says. “We’re all lab rats. Investors are lab rats.”

Count George Cipolloni, former bull, among the worrywarts.

Last year, when other investors were selling stocks and junk because of fear the U.S. was about to fall into another recession, Cipolloni, co-manager of the Berwyn Income Fund, bought by the armload, just as he did in previous market dips. Since 2009, his fund has returned 54 percent.

But he’s selling now, and piling up cash. It now accounts for 24 percent of the fund’s holdings, up from 7 percent about a year ago.

“We’re trying to be as risk-averse as possible,” Cipolloni says. “We don’t want to lose money.”

See also:

In a crummy economy, why are stocks soaring?

What would QE3 bring?

America’s 10 biggest IPOs


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