History points to upside for stocks after interest-rate cuts; Beware 'supposedly high-yield, no-risk offerings'; My friend Vitaliy Katsenelson warns about 'religion' stocks; Another Ukrainian love story

1) As you surely know, the big investment-related news recently was the Federal Reserve's 50-basis-point rate cut last week (which, as I mentioned in Thursday's e-mail, I wasn't surprised to see).

This has led to a rally in which both the S&P 500 Index and Dow Jones Industrial Average closed at all-time highs yesterday.

In addition to looking at current market conditions, investors are no doubt looking at history, which shows that stocks are almost always higher a year after the Fed starts cutting rates – as this Wall Street Journal article from yesterday notes: Here's What Happens to Markets When Interest Rates Fall, in Charts. Excerpt:

The Federal Reserve's big interest-rate cut last week is rippling through markets. With additional cuts expected in the months ahead, investors are looking to history to gauge what's next.

First, the good news: Since the 1980s, investments such as stocks and corporate bonds have tended to perform well in the 12 months after the Fed begins to cut rates.

That all depends, however, on how the economy fares. When growth holds up, or gets boosted by rate cuts, corporate profits tend to be strong. But if the cuts aren't enough to stave off a recession, investments of all kinds tend to suffer sharp declines. Think of the aftermath of the dot-com bubble and the 2008 global financial crisis.

Below is a table from research firm Bespoke Investment Group that a friend sent me – it shows what happened the previous 10 times in the past 40 years in which the Fed cut rates when the S&P 500 had risen at least 25% in the prior year (as is the case today). After a year, the market was higher in all 10 cases, with an average gain of 19.2%:

This next table from Bespoke shows what happened in the five instances (all in 2001 and 2008) in which the Fed cut rates when the S&P 500 had fallen at least 25% in the prior year. As you can see, it's a much more mixed picture – with stocks down a lot a year later after the two rate cuts in 2001 and up after the three rate cuts in 2008, with an overall average gain of only 1.4%:

And this last table from Bespoke shows what happened in the previous 15 times in the past 40 years in which the Fed cut rates when the S&P 500 was trading within 1% of its all-time high (as is the case today) – the market has been higher one year later in all 15 cases, with an average gain of 15.1%:

All of this history certainly bodes well for stocks over the next year!

2) As rates fall, investors become more and more tempted to stretch for yield – and may not be aware of the risks they're taking.

Here's a good example, recently exposed by the WSJ's Jason Zweig ahead of the Fed meeting: When Interest Rates Go Down, the Hucksters Spring Up. Excerpt:

For more than a year, earning high income has been as easy as rolling out of bed, with low-risk Treasury bills and money-market funds yielding at least 5%. Now, the Federal Reserve is expected to lower interest rates next month and yields are already shrinking.

So investors need to be on their guard against the inevitable rise in come-ons that prey on people's craving for high income.

It takes a lot to surprise a crusty old cynic like me, but a series of online offerings from an investment-advisory firm called Yield Wealth made my eyebrows go up recently. Earlier this week, several websites using Yield's name were promoting 10-year "term deposits" offering annual yields of up to 17.1%. Those numbers are extraordinary; high-yield bond funds yield about 7%.

As Zweig concluded (correctly):

... investors need to perform a lot of due diligence – more than ever. Yield's offerings won't be the last of their kind if interest rates fall. They're likely among the first in an onslaught of supposedly high-yield, no-risk offerings.

The old cliché, "If it sounds too good to be true, it probably is," is wrong. If it sounds too good to be true, it definitely is.

Here's his follow-up article from last week: Solving the Mystery of an Investment That's Too Good to Be True.

3) Speaking of risks...

At first glance of this article by my friend Vitaliy Katsenelson, The Hidden Risk in "Religion" Stocks, I was thinking to myself, "What a timely article – I'm glad to see that Vitaliy is seeing the same 'quality bubble' that I've been warning my readers about." Excerpt:

Gradually, investors turn from cautious shareholders into loud cheerleaders. Management is praised as visionary. The stock becomes a one-decision stock: buy. This euphoria is not created overnight. It takes a long time to build it, and a lot of healthy pessimists have to become converted into believers before a stock becomes a "religion."

Once a stock is lifted up to "religion" status, beware: Logic is out the window. Analysts start using T-bills to discount the company's cash flows in order to justify extraordinary valuations. Why, they ask, would you use any other discount rate if there is no risk? When a T-bill doesn't do the trick, suddenly new and "more appropriate" valuation metrics are discovered.

Other investors don't even try to justify the valuation – the stock did well for me in the past, why would it stop working in the future? Faith has taken over the stock. Fundamentals became a casualty of "stock religion." These stocks are widely held. The common perception is that they are not risky.

The general public loves these companies because they can relate to the companies' brands. A dying husband would tell his wife, "Never sell _______ (fill in the blank with the company name)." Whenever a problem surfaces at a "religion stock," it is brushed away with the comment that "it's not like the company is going to go out of business." True, a "religion stock" company is a solid leader in almost every market segment where it competes and the company's products carry a strong brand name...

Vitaliy then goes on to give an example:

Coca-Cola (KO) is a classic example of a "religion stock." There are very few companies that have delivered such consistent performance for so long and have such a strong international brand name as Coca-Cola. It is hard not to admire the company.

With Coca-Cola's stock today within a hair of its all-time high and trading at 7.2 times revenues and 29.1 times earnings, I was nodding my head in agreement.

And then I saw that Vitaliy originally published this article more than 20 years ago! What a great example of timeless wisdom...

Was Vitaliy right to warn about Coca-Cola? Well, yes and no.

On the day he published his article, March 22, 2004, KO shares closed at $24.13 (split adjusted). They closed yesterday at $71.73, so the stock is up 197% since then or about 5.5% compounded annually over 20 and a half years. That triple-digit gain is decent, but it's less than half of the S&P 500's gain of more than 420% over the same time frame. Take a look:

However, it's not a completely fair comparison. The S&P 500's gain includes reinvested dividends, and Coca-Cola pays a strong dividend, currently 2.7%, which the company has increased every year for the past two decades – a total of 272% – as you can see here:

If we assume that the dividend has averaged 2.5% per year and add that to the stock's roughly 5.5% return, that's about 8%. Compound that over 20 and a half years, and we get a total return of 384% – still lower than the S&P 500's return, but not nearly as much.

I think the lesson here is that if you pay full price for the stock of a large, high-quality company, you're likely, at best, to earn a similar return as the S&P 500 – so you're better off buying a diversified basket rather than one stock.

The key to investment success is to wait patiently until the market makes a mistake and you can buy the stock of a quality company at a bargain price.

4) I'm a sucker for love stories, so I want to share another one that I was a part of...

A year ago, a friend arranged a type of two-year refugee visa to the U.S. for the wife (Oksana) and son (Damir) of a Ukrainian soldier he knew, Artem. Damir has a disability and wasn't getting the support he needed in Ukraine.

This refugee visa requires an American sponsor to sign a legally binding contract to provide financial support if necessary, so I agreed to sponsor Oksana and Damir.

Their visa was eventually approved and they arrived early this year. Now, Oksana is working and Damir is happily attending school in New Jersey.

Artem misses his family terribly, of course... so my friend arranged a tourist visa for him to visit Oksana and Damir in the U.S. for a week.

By complete coincidence, I was in Kyiv and our itineraries lined up so we traveled together to Poland, and then flew yesterday from Warsaw to New York City, where I got to witness a beautiful reunion!

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.