News Column

St. Louis Post-Dispatch Jim Gallagher column

July 20, 2014

By Jim Gallagher, St. Louis Post-Dispatch

July 20--Federal Reserve Chairman Janet Yellen went to Congress last week and threw darts at little bubbles. We small investors should watch out.

Overall, stock and bond prices are within historical norms, she said. But prices in some sectors are "stretched." Leveraged loans, small-company stocks, social media and biotechnology stocks are the culprits, according to the Fed's report to Congress.

Such warnings from the Fed are extremely rare. The last came in late 1996, when Fed Chairman Alan Greenspan mildly suggested some "irrational exuberance" in stock prices. Of course, stocks rose for three more years before the technology bubble burst.

Still, when the Fed says watch out, smart investors listen. Let's see what Yellen is worried about.

It's nice that she has taken to pointing out bubbly parts of the bond market, since the Federal Reserve inflated them. By holding interest rates down, the Fed sent investors grubbing around for yield in increasingly risky places.

One of those places is in junk bonds, called "high yield" bonds by people who sell them. These are issued by companies too weak to make the investment-grade cut. They pay higher interest because they go broke more often.

Junk has had a nice run, although the group weakened a little this month. The Bloomberg High Yield Corporate Bond Index is up nearly 6 percent this year, and nearly 10 percent over the past 12 months.

But many investors have piled in, and they're driving junk yields down closer to bonds that are safer bets. The "spread" in yields between junk and no-credit-risk U.S. Treasury bonds is now 3.6 percent, a seven-year low, according to Merrill Lynch.

Lower yield means higher bond prices, which drives the index up.

On the one hand, that lower spread can reflect confidence in the economy. Good times mean fewer junk companies will default, justifying lower yields.

Or, it could just be the madness of yield-hungry crowds. Lately, officials of the Bank of England and the German central bank have worried publicly that junk is selling too dear.

Leveraged loans are made to companies that already have a lot of debt, or are otherwise shaky. Small investors get into this market through bank-loan mutual funds.

"Bank-loan funds have had more inflows than any other domestic fixed-income asset class recently, in part due to strong returns," said Charles Schwab in a recent note to clients.

But all that money rushing in has made loans available to even riskier companies, as the Fed noted.

In part, investors are looking for a hedge against the day that the Fed finally decides to push up short-term interest rates. The rates paid on those loans rise automatically when market rates do, although fund yields won't rise quite as fast.

The main worry is that novice investors have forgotten the risk in junk and bank loans. A surprise bump in the markets could send all running to sell at once. Prices could drop fast.

That's especially worrisome with bank loans, since the market for them could completely dry up.

"We believe that there's very little room for bank loan prices to rise, but plenty of room for them to fall if things take a turn for the worse," says Schwab.

Yellen's warning on small-cap stocks is a little late. The Russell 2000 small-cap index has lost 1 percent so far this year, compared to an 8 percent gain for the big-stock S&P 500 Index. Still, the Russell is trading at a rather rich 26 times this year's expected earnings, compared to 17 for the big caps.

Biotech stocks are still flying high. The Nasdaq Biotech Index is up 10 percent so far this year, although it's taken a hit this month. Stocks in the index are selling at an astounding 515 times company earnings. Investors are buying hope, not real profits.

At Argent Capital in Clayton, portfolio manager Ken Crawford has largely bailed out of biotech stocks. "I think the values are more full now than two or three years ago," he says.

Social media stocks look pricey as well. Facebook is selling at 90 times earnings, LinkedIn at 96 times this year's estimated profits.

There are signs of insanity here. The Securities and Exchange Commission this week halted trading in Cynk Technology Corp. after its stock soared 3,600 percent in 40 days. Cynk is supposedly an operator of a social network, although it had no revenue and only one employee. Some suspect that investors were being fleeced in a penny stock pump-and-dump scheme.

"It's crazy. You're seeing excesses like that. Social media stocks have been excessive for the last year," said Ray Saleeby, who manages $320 million at his namesake investment firm in Creve Coeur.

Saleeby notes that Yellen is an economist, not an investment guru, and she lacks real-world Wall Street experience. Still, he's paying attention. "I think she's right," he says.

Others are more sanguine about it.

Yellen pointed out the obvious, says Juli Niemann, analyst at Smith Moore & Company in Clayton. Sure small caps, biotech and social media stocks are up. They'll go down eventually, and something else will go up.

"We're in a rotational market," she says. Bond yields are miserably low, so more investors are hunting around for stocks. The result is a Ferris wheel, where some sectors ride high, swing low and ride high again.

Yellen's sectors on the top of the wheel now.

Jim Gallagher is a reporter at the Post-Dispatch


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Source: St. Louis Post-Dispatch (MO)

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