Signs of the top...

 Today's Digest is about "signs of the top."

 

Leading up to the financial crisis in 2008, we peppered these pages with "signs of the top" – market absurdities that only occur near market peaks.

 

Today, with the S&P 500 at all-time highs, we're seeing more and more of these absurdities. Mind you, we're not saying sell everything and lock your bunker...

 

We're just pointing out certain situations that don't occur under normal circumstances... and advising caution.

 

 There's probably no larger sign of the top than what's currently happening in the high-yield (aka "junk") bond market…

 

Investors are lending money to the riskiest corporate credits for near-record-low interest rates – currently a little more than 5%. And these companies literally cannot meet the demand for their paper.

 

This is also a reflection of a world that's starved for yield. Retirees need income to live, and pensions need to generate minimum returns to pay pensioners... The money needs to go somewhere to meet those objectives.

 

Still, desperate people do silly things.

 

 Porter explained in the May 16 Digest how he sees this playing out for investors wading into risky assets:

 

If the U.S. economy does weaken, then defaults on corporate bonds will begin to increase, substantially. The credit mix in the U.S. corporate bond market has never been weaker. The government's actions to save the major banks back in 2008/2009 allowed many poor credits that should have gone bankrupt to make it through the last recession.   Martin Fridson, the leading corporate bond analyst in the world, expects to see more than $1 trillion in corporate bond defaults, beginning in 2016. Fridson says the annual default rate will approach 10% at the end of this cycle. With interest rates on corporate bonds at less than 6%, there's simply no way that investors in the bonds are going to make money. They're not being paid nearly enough to make up for the risk of default.   That's why I believe the corporate bond market is "perfectly hedged": It's sure to fall, no matter what happens. If the U.S. economy rebounds strongly in 2015 and produces more growth than the market currently expects, then interest rates will rise – especially as the Fed stops supporting the market with the end of quantitative easing. In that scenario, corporate bonds will fall as interest rates rise. If this happens, it's possible that earnings growth in big companies will increase enough to prevent a full-blown bear market in stocks. But a correction of 10% in the major indexes is still likely.   On the other hand, if fears about economic growth are valid, then default rates are going to soar. It's likely that 30%-40% of all the issues currently outstanding will default during the next credit cycle. Fears of these future default rates would cause the corporate bond market to collapse. Interest rates on corporate loans would move to more than 10%. In this scenario, I'm certain you'll see a full-blown bear market in stocks (a fall of 20% or more in the major indexes).

 

 Still, high-yield debt is more popular than ever today...

 

According to the Wall Street Journal, of the 10 largest U.S. bond funds at the end of 2013, the four with the fastest growth in assets since 2008 held an average 20% of their portfolios in junk bonds.

 

The other six funds – which include PIMCO's Total Return Fund managed by Bill Gross – hold an average of 1.4% of their portfolio in junk bonds.

 

One of the biggest winners of late in the bond world is the Total Return Bond Fund managed by Jeffrey Gundlach at DoubleLine Capital. His fund holds 28% of assets in junk paper.

 

"Who wants an index fund that yields 2%?" Gundlach told the Journal. Investors "want exposure to these high-yield and distressed securities," he added, "and they've become comfortable with what we're doing."

 

 Gundlach's Total Return Bond Fund currently has $32.1 billion under management, up 10 times from its start four years ago.

 

Meanwhile, investors have pulled $55.3 billion from PIMCO's Total Return Fund since May 2013. The fund lost 17% of its assets last year. (Of course, it's still the world's largest fund, with $230 billion in assets.)

 

Nobody ever heralded the individual investor for his timing...

 

 Robert Lee of asset manager Lord Abbett & Co. is another winner in this dash for yield. His fund grew by $5 billion (19%) in 2013. And he has doubled the return of his peers over the past three years.

 

"We've gone out the risk spectrum some," Lee told the Journal. "The fundamentals of corporate America are still pretty good and default rates are pretty low."

 

What could go wrong?

 

 If you want the greatest sign of the top in the junk-bond market, consider this...

 

What should you do if the 5% you're earning in junk bonds doesn't meet your income needs? Lever up and buy more junk bonds, of course.

 

We present the below paragraph from Bloomberg without comment about a new fund that wants to begin trading its shares. Keep your eye on the words "pensioners" and "bets":

 

The AdvisorShares Pacific Asset Enhanced Floating Rate ETF will use derivatives to boost gains on high-yield loans, allowing retirees and pensioners to magnify bets on debt that promises higher yields when interest rates rise, according to a U.S. regulatory filing. The fund, which would be actively managed, is currently pending approval from the U.S. Securities and Exchange Commission.

 

 Meanwhile, the founder of the world's largest asset manager, BlackRock's Larry Fink, says these leveraged funds could "blow up" the industry.

 

Fink's firm manages $4 trillion. It's also the largest player in the exchange-traded-fund world with $1 billion in its "iShares" funds.

 

"We'd never do [a leveraged fund]," Fink said at a Deutsche Bank conference in New York. "They have a structural problem that could blow up the whole industry one day."

 

 Another sign of the top...

 

With the U.S. markets at all-time highs, companies are buying back a record amount of stock.

 

Financial blog Zero Hedge, citing numbers from data service Capital IQ, notes S&P 500 companies repurchased $160 billion of their own stock in the first quarter – making them the largest buyers of stock for the quarter.

 

Should that pace continue into the second quarter, the 12 months ending June 30, 2014 would tally the greatest amount of corporate buybacks in history.

 

 Of course, companies buying back their stock can be a good thing. A company allocating capital to repurchase stock at discount prices can be a wonderful investment. But that's not the case today.

 

We asked Extreme Value editor Dan Ferris for his thoughts on corporate buybacks today. He told us:

 

The overwhelming majority of companies tend to be bad at buying back stock. Most buybacks don't create value. They destroy it. In finance, when everyone jumps on board, it rarely (if ever) turns out well.

 

 He added that one type of company has more leeway when buying back stock – World Dominators. This is the term Dan coined to describe companies that are the No. 1 businesses in their industries… maintain rock-solid balance sheets… and generate tons of cash. Dan noted…

 

World Dominators tend to make great share repurchasers because the value of their business is constantly rising, so they can buy back at a wider range of prices and still create value. Of all the World Dominators I've recommended, IBM has been the best repurchaser. It has lowered its share count nearly 40% the last decade. Coincidentally, it's the only World Dominator left in buy range today, as Apple and Cisco recently surged higher.

 

 

 New 52-week highs (as of 5/28/14): Blackstone Mortgage Trust (BXMT), CVS Caremark (CVS), AllianzGI Equity & Convertible Income Fund (NIE), Sanchez Energy (SN), Superior Energy Services (SPN), and ProShares Ultra 20+ Year Treasury Fund (UBT).

 

 Lots of responses to subscriber Tom Nugent in today's Digest. Send your feedback to feedback@stansberryresearch.com.

 

 "I am at a bit of a loss as to why Tom Nugent thought the end of May was the drop dead date for China to become the world's reserve currency. If he would take a moment to chill out and think before he types, he might be able to look around the world at all of the trade deals China is establishing with countries using their own currencies rather than the U.S. Dollar.

 

"Tom, please take note that the function of the world's reserve currency is to serve as the standard monetary instrument in the conduct of global trade. When other countries begin trading internationally with their own currencies and cease using the U.S. Dollar, we are losing our status as the world's reserve currency.

 

"I am sorry you have been disappointed by the lack of a formal announcement or overnight transition; but, that is simply not the way this sort of shift takes place. You need to think these things through and understand your topic prior to launching a tirade if you want to avoid the appearance of ignorance; especially when including your last name.

 

"By the way, are you related to Ted?" – Paid-up subscriber Ken McGaha

 

 "Patience is a virtue." – Paid-up subscriber BT

 

 "I don't recall any of you stating that the yuan would be the world's reserve currency by the end of May.

 

"Does Screamin' Tom have some inside info that you didn't share with the rest of the world?

 

"Well, at least he's paid up." – Paid-up subscriber Al

 

Regards,

 

Sean Goldsmith

Dallas, Texas

May 29, 2014

 

Editor's note: This week, we've been sharing insight from Tom Dyson, publisher of our corporate affiliate the Palm Beach Letter, on his strategy for investing in companies that routinely pay large special dividends. Today's Digest Premium continues that discussion and has been adapted from the December 12 issue of the Palm Beach Letter.

 

 

 The average American teen spends $1,150 each year exclusively on apparel. In fact, according to a 2013 market research study by Piper Jaffray, the fashion category accounts for roughly 40% of teen budgets.

 

And as all parents out there know, whatever teens can't afford themselves, they beg their parents for.

 

 Buckle (BKE) sells these trendy clothes – casual clothing, shoes, and accessories. You'll see its stores under the names "Buckle" and "The Buckle."

 

The company targets middle- and upper-income young adults – or, as Buckle calls them, "fashion-conscious young men and women." We'll translate that for you... "trendy teenagers and young adults."

 

Buckle now has more than 450 stores in 43 states. Even with that, it's still expanding... but at a conservative and sustainable rate (unlike most retailers). It opened just 13 new stores in 2013.

 

 The company features popular brand names such as Fossil, Hurley, Oakley, and Puma, to name just a few. Plus, Buckle markets its own branded items.

 

But carrying sought-after brands is only part of what makes Buckle unique. Its main distinguishing feature is its focus on creating a five-star shopping experience for its customers...

 

 Buckle's stock is cheap. It's trading at a price-to-earnings ratio of just 13.

 

It's safe. It has no debt and almost $200 million in cash.

 

It's growing. In the last five years, revenues grew 42%.

 

And it's profitable. Net income has risen 58% in the last five years, too.

 

 Buckle is also focused on rewarding its shareholders.

 

The company recently raised its quarterly dividend by 10% to $0.22 per share. The stock currently yields 2%.

 

Buckle also buys back a lot of stock. Since 2004, Buckle has repurchased $154 million of its stock. And it times those purchases to take advantage of sagging share prices.

 

But what we like best about Buckle is its history of paying special dividends...

 

 Buckle has paid a "holiday" dividend the last five calendar years. I write "holiday" because the company tends to announce the dividend around one of two holidays. Some years it's closer to Halloween. Other years, it happens closer to Christmas.

 

Regardless of when Buckle announces it, this isn't a small special dividend. Take a look for yourself...

 

 

This table shows Buckle's holiday dividend payments since 2008 as well as its yield:

 

And remember, this is in addition to Buckle's quarterly dividends.

 

 If we combine quarterly and special dividends, we can calculate BKE's annual dividend yield. Using fiscal year-end pricing, BKE's total dividend yield is gigantic. In four of the last five years, it has been in the double digits.

 

Buckle is all about returning cash to its shareholders – through regular dividends and/or special dividends.

 

The company has a strong history of being shareholder-friendly. So we're going to use two shareholder-friendly methods to project our returns.

 

First, we'll start with regular dividends. As I told you earlier, Buckle increased its regular quarterly dividend to $0.22 last December. That sets the annual cash dividend at $0.88 per share. At today's market price, that's a 2% dividend yield.

 

Second, let's revisit Buckle's generous special-dividend history. Referring to our table, the average special dividend yields 8.3% per year. That spans the five-year period from 2008 to 2012.

 

A 2% regular dividend yield and an 8.3% special-dividend yield... That's a 10.3% return each year.

 

It's rare to find such a safe company paying such a high yield in today's market.

 

That's why we recommended buying BKE up to $55 per share. (And we recommend holding it with a 25% trailing stop.)

 

– Tom Dyson

 

 

Editor's note: Tom says the most exciting income idea in the Palm Beach Letter portfolio right now is another special-dividend-paying company. The stock has paid a special dividend for 11 straight years and averages more than 10% per year in dividend payments.

 

Warren Buffett once owned this stock. Benjamin Graham, the father of value investing, used this company as an example throughout his books. It has no debt and 12% of its market cap in cash. Insiders own more than 30% of the company, so you know the dividends will continue. And it sells military hardware, health care products for seniors, and kitchen appliances, so it's recession-resistant. To learn more about a Palm Beach Letter subscription – which gives you access to Tom's work on this company – click here.

One of the safest companies paying a 10% dividend today...

 

In today's Digest Premium, Palm Beach Letter editor Tom Dyson discusses one of the best special-dividend-paying companies in the market today.

 

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