Which of Bernanke’s Statements Should We Believe?


Dear Reader,

Vedran Vuk here, filling in for David Galland. In today's issue, I'll review Ben Bernanke's testimony before the House Financial Services committee. I suppose that it's good news to note the lack of a major reaction to Bernanke's recent appearances. Interest rates have not continued to rise at a dizzying pace—although they're certainly heading up in the long run. And the market didn't have a major correction nor an unwarranted boom.

After Bernanke's comments, the ten-year Treasury yield did move down below 2.5%, but looking at it this morning, it appears to be up over that level again. As rates have risen, Fed members have attempted to refine their message in order to push rates back downward a bit. It's been a lot of talk with very little movement in interest rates—perhaps the market has caught on to their game. While interest rates on the ten-year Treasury have moved as high as 2.73% in recent months, they are now a little lower at 2.54% after much convincing from the Fed that tapering was still far away.

After my review of Bernanke's testimony, Dennis Miller will have an important article on what were once considered "widow and orphan" stocks, i.e., utilities. As interest rates have been rising, these traditionally secure stocks have been hit relatively hard. If you own utilities or are thinking about adding some to your portfolio, this is a must read.

Bernanke Reveals His Plans, Then Tells Us to Ignore Them


With Fed Chairman Ben Bernanke giving what may be his last testimony before the House Financial Services Committee, Congresspeople on both sides of the aisle poured their hearts out to Bernanke for his "service." In this Bernanke love-fest, he was repeatedly thanked for saving the economy from an even worse fate than what has transpired so far. Irony abounded in the questions following the compliments, however. One second, Committee members are praising him for doing a good job and the next, they're asking him to do something about the exceptionally high rate of unemployment.

In the hearing, Bernanke didn't reveal much new information... and apparently the new class of aides on Capitol Hill is a poor one, as the pre-written questions hardly challenged the Fed chairman. Much of the hearing was wasted with questions which allowed Bernanke to repeat his opinions about the negative effects of the sequester. Anybody who follows Fed policy closely already knows Bernanke's response: he thinks it's causing a drag on the economy.

Aren't you glad to hear some of our Congressional representatives waste question time with the most powerful monetary authority in the world to score a few cheap political points? Other members of Congress used this valuable time to inquire about the economic effects of the immigration bill. Sure, that's an important topic, but it's only peripherally related to the country's interest rate policy.

After hearing the over three hours of testimony, I could only identify two pieces of information that are relevant to an investor's decision-making process. First, Bernanke gave us a much clearer picture of when he plans to taper. In the past, we've been told that interest rates will be pulled up when the unemployment rate is around 6.5% and inflation is near 2%. Now, we're getting some metrics on tapering asset purchases as well. According to Bernanke, asset purchases could taper later this year, if inflation is around 2% and unemployment is around 7%.

When interest rates rose in recent months, many investors speculated that tapering could come as early as September. But with the unemployment rate at 7.6%, there's almost no way to meet Bernanke's metric of 7% in that short period of time. So, if he does taper the Fed's asset purchases, I would foresee it beginning near November or December—if at all this year. The market had become overly concerned, and as a result, Bernanke gave it some clarity.

Here's the contradictory part: Though Bernanke gave this guidance, he kept saying that there's no set plan on policy. It can change with economic conditions and circumstances. The Fed will stay accommodative as long as it needs to. So on one hand, he's giving precise numbers like 6.5% and 7% unemployment, and on the other hand, his message seems to be, "Don't pay attention to those numbers too much. We're just going to play it by ear." Kind of confusing, in my opinion. Does the Fed want the market to pay attention to those metrics or not?

The answer is probably somewhere in between. The Fed wants to set guidance, but doesn't want the market to panic. While its intentions make sense, its statements are inherently contradictory in many ways.

The other significant statement came after one Congressman decided not to waste his time to score political points. He asked a very simple but extremely important question about the recent rise in interest rates and what Fed was going to do about it.

Bernanke responded by saying that it's too early to tell. However, he said that his benchmark for evaluating whether the Fed needs to take action to lower interest rates again is the real estate market. For right now, real estate is still moving higher despite higher mortgage interest rates. However, if the real estate recovery falters, then the Fed will take action to push rates downward again. For investors, that means "watch real estate!," because that's what the Fed is watching. But it also tells us that the Fed is somewhat comfortable with the current rise in rates. If everything keeps moving smoothly, it's not going to rock the boat and push rates back down. Some of the Fed's announcements have lowered rates slightly, but we probably shouldn't expect anything more than words in the short run. Again, not a whole lot from his statements this time around, but we do have two things to closely keep our eye on now—near 7% unemployment and faltering real estate prices—as two key trigger points.

Getting Shocked by Utility Stocks

Dennis Miller, Senior Editor, "Miller's Money Forever"

Since the bulk of our subscribers are retirees or people approaching retirement, the Money Forever portfolio is designed to be defensive, meaning it minimizes risk but still has the potential for growth and income. Historically, this would have meant including a few widow-and-orphan stocks in our portfolio—public utilities with nice dividends.

Utilities experience little volatility, their dividends are solid, and the demand for their product is constant, regardless of how well the economy is doing. Government regulation also gives them a leg up, since utilities face little competition. They set their rates, consumers pay those prices because they have limited alternatives, and the utilities turn a profit.

So, is it time to add one or two utilities to our portfolio? As I talked through the idea with Vedran, I could hear him clicking away on his keyboard in the background. A little research on a couple of utilities quickly put things in perspective. Had we bought in to Exelon (EXC) in early May at the wrong time, we almost would have been stopped out by a 20% trailing stop, since the stock fell as far as 19%. We were both shocked.

But that's only one utility. What about the sector as a whole? With a few more clicks, we learned that the Utilities Select Sector SPDR (XLU), a $5.4-billion exchange-traded fund of utilities, had fallen as far as 11% since the beginning of May. That's an enormous move in such a short period of time for what many consider a staple sector for retirement portfolios.

Wait a minute here! Utility stocks are supposed be the ultimate safe investment. They didn't earn the nickname "widow and orphan stocks" for being volatile, so what the heck happened?

History Does Not Guarantee Future Performance

Vedran did an in-depth analysis and offered up a bit of a history lesson for me to pass along. Let's start with where defensive stocks stood prior to the rapid rate increase in Treasuries. With yields near record lows, investors piled in to dividend stocks in search of income. But they didn't pick just any type of stock—they specifically chose defensive stocks with a beta of less than one. For a quick review, a beta of one means a 10% move in the stock market should theoretically move the stock 10%. A beta of 0.5 means a 10% move in the market should move the stock only 5%.

In addition to retail investors, more sophisticated analysts suggested moving in to these stocks as well. One of the most common Wall Street valuation models examines three primary factors: dividends, beta, and the US Treasury rate. When the beta and Treasury rates are low and the dividend is high, a stock is shown to be more valuable. Based on this model, a stock's value is more dependent on Treasury rates and the dividend than what often drives value: cash flows and growth.

In a nutshell, because there are no safe, decent interest-bearing investments available, many billions of dollars went into utility stocks. In some sense, utilities began to act like bonds. And when interest rates rise, bond prices fall. As a result, what was once considered the definitive stable investment is now interest-rate sensitive, just like long-term bonds.

In order to get a better visual of what's been happening, Vedran tracked XLU's performance since May 1—a period of rapidly rising rates—and compared it to a theoretical beta-based utility performance as well as the S&P 500. With a beta of 0.63, XLU should move 6.3% whenever the market moves 10%. In many situations beta works well, but unfortunately, it doesn't capture every risk, including interest-rate risk.

The blue line traces the return on the S&P 500. The green line depicts how XLU theoretically should have moved based on its beta. The red line shows how it actually performed. Note the enormous difference, bottoming out as far as 11.2% down.

Although beta is typically used as a back-of-the-envelope measure of risk, it's not doing a particularly good job for utilities in a rising-rate environment. And while the S&P 500 has recovered from June's turbulence, utilities are still down for this period.

After I saw the data, I asked Vedran what to expect in the future. While I suppose it makes little difference if a retiree is holding utility stocks for the dividends, utilities will likely lose value as interest rates rise. That can be a bit unnerving.

This could be a real problem for retirees, as it's common practice for investment advisors at major brokerage firms to put their more conservative investors in utilities. A seasoned veteran once told me that no broker ever got sued for putting clients' money into utilities. I wonder how many brokers and investment advisors have noticed this shift happening in utilities with higher rates.

In light of rising interest rates, we have refined our criteria for selecting solid and safe investments for the Money Forever portfolio. Unfortunately, not everyone was has caught on. Take a look at your portfolio to see whether you need to trim down your utilities exposure. Should the market crash, I'd rather be holding a utility than General Motors, but at the same time, if interest rates keep going upward, utilities will feel the pain.

For more on dividend-paying companies and investments—especially those less affected by rising rates—check out our latest issue of Miller's Money Forever.


Friday Funnies

Louis James from the International Speculator passed on this hilarious scam email. It's a scam promising to compensate people who have been scammed. Notice the absolutely horrendous spelling and grammar throughout:

"With due respect world bank have set aside 25million dollars for compensation for those who has defrauded by different country all over the world, in view of this, world monetary unit, is now duly accredited for these payment, to save human life as World has come up with the option of payment for various individuals who has been scammed by people round the globe.

To clear you up who has been a victim you will only receive the half payment you are excepting as compensation. Note that the body has five branches worldwide which headquarter is in Switzerland representing Europe and also other branches are Asia, South and North America, Africa respectively

To get this done you have to contact the Director World monetary payment unit Via: Email xxxxxx@xxxx.com

Contact :Ms Maureen Hart,It is left for you to choose your option center anywhere also you have to provide with your information's for verification on where the transaction took place.

Your letter will be look into

Thanks Johnson Dole"

I recently found an article from the Daily Caller making fun of the Federal Reserve's Twitter account started last year. The article notes ten funny Twitter responses to the launch of the Fed account.

@agaiziunas: Oh great, @federalreserve has joined twitter; this time next year every tweet will only be worth half its original value due to inflation

@nycsouthpaw: Has anyone made a quantitative tweeting joke yet? @federalreserve

@dwangelo: @federalreserve please please please follow me. I use your money all the time!

@mamaswati: omg someone please tell me @federalreserve is a parody account for the love of all things funny.

@BradMaan: @federalreserve Im in 11th grade, why are are [sic] you punishing my generation’s future with your policies of greed and middle class destruction?

@davidjkramer: @federalreserve Since you guys just create money out of thin air, what really is the purpose of the IRS anyway?

@ManDayCeo: Dear @federalreserve : Thanks for the high gas prices and screwing us over and over again. #YourHooker #TheAmericanPeople

@Dave_Aiello: I wonder if @federalreserve created new money to purchase their twitter username from the previous owner #EndTheFed #soundmoney #RonPaul2012

@MattThorntonAZ: @federalreserve Ben, can I please borrow your printing press just for one night – I need a personal bailout. Thanks!

@The_Real_Kev: @federalreserve : can't wait to see your 140-character farewell address!

And now for a funny T-shirt on how far the esteem of the economics profession has fallen since the 2008 crisis:

That's it for today. David Galland should be back next week. Thank you for reading and subscribing to the Casey Daily Dispatch.

Vedran Vuk
Casey Senior Analyst

Jul 19, 2013
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