Understanding QE and What It Means for Your Portfolio

by Lawrence Meyers | January 25, 2013 8:00 am

I recently got to sit down with a couple of CEOs and economists to clarify what quantitative easing is really all about. It turns out I was wrong about a few things. This explanation will help guide you with regard to stocks, explain why bond yields have cratered and how to find other fixed-income investments.

The Demand Side of the Equation

In “normal times,” the U.S. would generally see 1.8% to 2% real productivity growth and about 1% population growth. Add those up, and real GDP growth should be 2.8% to 3% annually. Alas, we’re growing in the 1% t0 2% range.

The reasons go back 20 years, or more. The American consumer and government borrowed trillions against the future’s GDP. Well, all debt has to be paid off at some point, and the piper has come to call.

Americans are now deleveraging, and the process won’t happen overnight. It will take years, maybe even decades. Since the economy grew on borrowed money, it will shrink without it. That would cause a recession, and that’s why the Fed started QE.

The Fed prints money to buy bonds issued by the Treasury. This keeps interest rates low, encouraging businesses to borrow at cheap rates, and thereby helping move the economy along.

But won’t printing all this money cause inflation?

No Inflation

You probably learned in middle school that inflation is defined as “too much money chasing too few goods.” Actually, however, it is “too much money and credit chasing too few goods.”

The reason we haven’t seen much inflation over the past 20 years is that credit was flowing but the money supply was not.

Consumer deleveraging is now choking off some of that credit flow. This permits the Fed to increase the money supply, offsetting that reduced credit flow, without causing inflation.

So Why Isn’t the Economy Recovering?

We now know that, in theory, the Fed will be able to keep the economy afloat without causing inflation. Unfortunately, that’s only half the story.

The other half involves our beloved politicians.

The economy can’t recover because of too much government spending. The nation has a $1.1 trillion deficit, so the government must borrow to meet that deficit at a time when it needs to deleverage instead. However, it must deleverage gradually, at a rate that’s offset by the 1% to 2% GDP growth that we’re seeing.

Yet, the government just keeps borrowing! Total public and private debt is around $55 trillion — that’s 350% of GDP. We’ve seen this outrageous ratio before: in Japan. That country’s public debt as a percentage of GDP went from 70% to 220%, while its consumer deleveraged. How’s that working out for Japan? Does its 20-year economic debacle answer that question?

If America wants a return to economic growth, the government must stop borrowing. If it doesn’t, the market may force it to. That could happen after severe credit rating downgrades, which would push up interest rates. That, in turn, would slow the economy and decrease tax receipts, which creates an even worse deficit. And this just continues.

That’s what it means when you hear people say we’re going to look like Greece in a few years, because that’s what’s happening over there

But until the ratings agencies all get rumbling about credit downgrades, the stock market should be a relatively safe place to selectively invest (more on that shortly).

The Supply Side of the Equation

Could American business help grow GDP? Absolutely! In order for that to happen, businesses need to produce goods and services. Alas, many uncertainties prevent businesses from investing capital.

And wouldn’t you know it, those uncertainties are caused by our beloved politicians. Is anyone seeing a pattern here?

President Obama loves regulations, which cost money to implement. By some estimates, every $100 billion of regulations costs America some 0.7% in GDP growth. So, you’d figure that if Obama wanted the economy to grow, he’d remove regulatory burdens. Instead, he’s adding to them. Go figure.

How about the uncertainty over Obamacare? Businesses have been trimming hours and workers to avoid having to provide insurance by coming in below certain minimum thresholds. That creates more uncertainty, as in, how many people will be added to the unemployment roles? Joblessness results in less earned income, which results in less consumer spending to increase GDP.

Still, from an investment perspective, the stock market isn’t directly impacted.

Investor Guidance

It’s essential to understand, now more than ever, that growth in earnings per share isn’t merely the result of top-line revenue growth. It’s also affected by cost cuts and stock repurchases, which decrease the number of shares outstanding. This lowers the denominator in EPS, lifting the EPS number overall.

So make sure the company you’re buying into isn’t suffering the effects of what I’ve written about, and is masking slack growth using these other methods.

What stocks make sense in this environment? You want consumer staples, like McDonald’s (NYSE:MCD[1]), Altria (NYSE:MO[2]) and Target (NYSE:TGT[3]). You want dividend-paying stocks, like Verizon (NYSE:VZ[4]), Kinder Morgan Energy Partners (NYSE:KMP[5]) and 3M (NYSE:MMM[6]).

You want to be all over preferred stocks, which provide great stability with their bond-like trading behavior. I love Ashford Hospitality Trust (NYSE:AHT[7]) Series D, which is an 8.45% issue. Bank of America (NYSE:BAC[8]) has several offerings yielding 4.5% to 6.5%. Duke Realty (NYSE:DRE[9]) has a few issues in the 6.5% range. Public Storage (NYSE:PSA[10]) has a slew of preferred shares paying 6.5% or more.

Finally, have a look at business development companies[11]. They invest in fast-growing middle-market companies, using mezzanine debt and warrants to augment returns. Prospect Capital (NASDAQ:PSEC[12]) invests in late-stage venture, middle-market and mature companies. It also gets involved in buyouts and recapitalizations. It pays a monthly dividend (11.3% annual rate).

Triangle Capital (NASDAQ:TCAP[13]) focuses more on leveraged and management buyouts, acquisition financing and growth financing. It pays 8% annually and distributes quarterly. BlackRock Kelso (NASDAQ:BKCC[14]) yields about 9.9% and is one of the premier names in private equity. UBS ETRACS Wells Fargo Business Development Company ETN (NASDAQ:BDCS[15]) is a great diversified play and pays about 6.98%.

As of this writing, Lawrence Meyers didn’t own any securities mentioned here.

  1. MCD: http://studio-5.financialcontent.com/investplace/quote?Symbol=MCD
  2. MO: http://studio-5.financialcontent.com/investplace/quote?Symbol=MO
  3. TGT: http://studio-5.financialcontent.com/investplace/quote?Symbol=TGT
  4. VZ: http://studio-5.financialcontent.com/investplace/quote?Symbol=VZ
  5. KMP: http://studio-5.financialcontent.com/investplace/quote?Symbol=KMP
  6. MMM: http://studio-5.financialcontent.com/investplace/quote?Symbol=MMM
  7. AHT: http://studio-5.financialcontent.com/investplace/quote?Symbol=AHT
  8. BAC: http://studio-5.financialcontent.com/investplace/quote?Symbol=BAC
  9. DRE: http://studio-5.financialcontent.com/investplace/quote?Symbol=DRE
  10. PSA: http://studio-5.financialcontent.com/investplace/quote?Symbol=PSA
  11. business development companies: https://investorplace.com/2012/12/6-investing-lessons-from-bdcs/
  12. PSEC: http://studio-5.financialcontent.com/investplace/quote?Symbol=PSEC
  13. TCAP: http://studio-5.financialcontent.com/investplace/quote?Symbol=TCAP
  14. BKCC: http://studio-5.financialcontent.com/investplace/quote?Symbol=BKCC
  15. BDCS: http://studio-5.financialcontent.com/investplace/quote?Symbol=BDCS

Source URL: https://investorplace.com/2013/01/understanding-qe-and-what-it-means-for-your-portfolio/
Short URL: http://invstplc.com/1nylvnd