The Dow 20000 Man Sees a ‘Safety Bubble

http://www.wsj.com/articles/the-dow-20000-man-sees-a-safety-bubble-1480907342?mod=whatnext&cx_navSource=cx_picks&cx_tag=poptarget&cx_artPos=2#cxrecs_s


 In mid-2012, when Seth Masters said the Dow Jones Industrial Average would cross 20000 by 2020, he took a lot of flak for being a cockeyed optimist.

Mr. Masters, chief investment officer at AllianceBernstein’s Bernstein Global Wealth Management, made the call with the Dow at 12500, when stocks were in the middle of a long bull market, and coming off a debt crisis in Europe. Many felt that central-bank policy around the world would cause a meltdown.

“We felt there was a lot of evidence that the financial system had, in fact, done a remarkably good job of healing itself, especially in the U.S.,” Mr. Masters says. “The corporate sector was becoming surprisingly healthy, and so there was really a once-in-a-generation type of opportunity to take advantage of a misperception of reality.” As stocks rose, he sped up his timing, calling for Dow 20000 by 2018.

With the benchmark past 19000 and less than 5% from Mr. Masters’s target, you would think he would be in the clear. But he also has predicted the bursting of a “safety bubble” in dividend-paying stocks that could slow the Dow’s advance.

Here are edited excerpts from a recent interview:

WSJ: Did you ever regret sticking your neck out with a number attached to your forecast?
MR. MASTERS: The really dangerous thing is to come out with a number and a date. That’s why when we wrote the original piece I made a point to frame our forecast as a median and talked explicitly about ways we could be wrong, especially on the downside. Sure, there are times when you think you’ll be wrong, but from 2012 to 2014, we were wrong because we hadn’t been optimistic enough. That’s why in 2014, we put out an update that said “We’re ahead of schedule for Dow 20000, but don’t expect the markets to do nearly as well from here to 20000 as they have from 2012 to 2014.”

WSJ: By 2015, you were talking about the safety bubble. How did the market create that problem in the middle of a bullish run?
 
MR. MASTERS: There was—and is—some legitimate paranoia about if we would ever really be safe again. Even as people became more optimistic, they craved safety in the wake of the [2008] financial crisis. But when lots of investors start thinking it’s a great time to pile into utilities and telecoms and consumer staples and other dividend-rich, relatively stable companies, their price goes up. As that happens, [safe stocks] become risky, because there is a point where anything is so expensive that it’s risky.…By 2015, we started seeing many of these safe companies priced at 20% to 30% premiums to the market [on a price/earnings ratio basis], and that didn’t make sense.
As a result, people hedged their bets and exposed themselves primarily to assets they perceived as safe. The obvious safe asset is an investment-grade bond, so the analogy that carried over to equities was for stocks that, as much as possible, have bondlike characteristics, or relatively stable businesses that don’t grow that fast but aren’t likely to blow up. Because they aren’t growing that fast, they have the ability to pay a lot of dividends, so they have a fair amount of yield like bonds, as well.
Having a lot of your return come in the form of yield gives you in general less volatility, but the market historically values companies of that type at a discount because it’s logical that if things don’t grow much you probably shouldn’t value their future potential as highly. As a result, yield-oriented safer stocks as a group historically have traded at about a 7% to 10% discount to the market overall.
WSJ: How does the safety bubble play out?

MR. MASTERS: As interest rates have started to go up, investors who bought safety stocks are experiencing a double whammy. First, because these stocks are bondlike in their characteristics, they’re interest-rate sensitive, so rising rates are bad for them. That isn’t what people expected…so people are beginning to dump them. Thus, from both a risk and a diversification standpoint, it turns out these safe stocks aren’t so great. So over the next few years we will see a slow leak out of the safety bubble.

The other realization hitting people who bought these stocks is, “If rising rates actually lead to this type of stock underperforming, then my safe-stock portfolio will actually do the same thing as my supposedly diversifying bond portfolio. Whoops, that’s not a good outcome either; my diversified portfolio isn’t so diversified.”

WSJ: That creates a headwind for the market. Does it stop the Dow from reaching your target?
 
MR. MASTERS: The rest of the market has pretty attractive stocks in it as long as we have some economic growth, which it looks like we are getting. We’re pretty optimistic you will get an opportunity to have overall market growth, but at a more subdued rate than we experienced in 2012-13-14. Obviously, there will be a correction at some point, and what is hard to know is whether it will happen before or after we hit 20000. But what we can say with confidence is that we will ultimately end up going through the 20000 level more than once because there will be more volatility ahead.
Mr. Jaffe is a MarketWatch columnist. Email him at cjaffe@marketwatch.com.