Stocks have stayed largely in reverse gear in the last week following weaker-than-expected earnings reports and a continued rout of commodities, energy stocks and high-yield bonds.
When you put all three of those bad boys into one big concept, you get master limited partnerships, which are yieldy plays on energy production bought largely for safety and income.
The irony is painful. MLPs are largely owned by wealthy investors as a conservative way to clip dividend coupons while still retaining a stock kicker. But the only kick this year has been to the teeth, as the JP Morgan Alerian MLP (AMJ) fund, which is a good proxy for the group, sank another 2.7% on Wednesday and is now down a whopping 18% for the year.
Most investors in MLPs think that the yield they receive comes from oil and gas pipeline revenue. But the dirty little secret of the group is that their managers typically finance the yield by taking on debt. Since these companies typically have skimpy assets to put up as collateral, their bonds are typically of the junk variety.
So right now you have MLPs going down because of their exposure to energy and because of their exposure to high-yield debt. They tend to be thinly traded despite their size, and have no natural constituency except the people who are already filled to the gills with them due to the fact that they have been one of the few reliable ways to pick up a 4%-5% yield.
You can blame the Federal Reserve’s zero interest rate policy, or ZIRP, for its role in this mess and you won’t get any argument from me. Impossibly low interest rates on government bonds have forced conservative and elderly investors out of the yield curve, where they have had to take on a lot of risk to get income. The policy made sense back in 2009-10 when fiscal and monetary authorities were trying to get people to take more risk after the credit crisis of 2007-08, but ever since it has been a perverse scourge of a swath of the investing public that can least afford to make missteps.
Imagine the pensioner who had $1 million in MLPs paying 5% to generate $50,000 in annual income. Now she’s down $180,000 this year and the yield is in danger because these companies may have to suspend or cut their dividends just to stay afloat. Some of the more famous MLPs are seeing an absolute fire sale as it looks like pensioners are dumping at any price: The $55 billion Enterprise Products (EPD) is down 22% this year, while the $16 billion Plains All American (PAA) is down 21.5%.
It’s entirely possible, maybe even probable, that these are good buys at current prices because they are so heavily oversold. Plus PAA is now yielding 6.9% per year while EPD now yields 5.3%. But history shows that this group does not experience V-shaped bottoms, typically taking six months to a year once they finally stop going down every day, which has not happened yet.
My greater concern about the MLPs — which I have not favored for more than a year in part because of their overuse of credit to pay dividends — is their role as canaries in the coal mine. When investors become adverse to high-yield debt and the companies that issue them, the fearfulness and despair typically spills over into less risky instruments. This is a serious red flag. More on this topic next.
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HAIRY BONDS
While stock indexes were at one-year highs a week ago, high-yield bonds were selling off and making new one-year lows. In the past three decades, the only time stocks shrugged off a high-yield credit collapse to this degree was 1999-2000, according to analyst Jason Goepfert, of Sundial Capital.
The iShares iBoxx High Yield Corporate Bond fund (HYG) has been down seven days in a row through Monday, and is now down 4% from its high in the spring, which is a lot in credit-land.
This pattern of new highs in stocks coupled with new lows in bonds has happened during 48 sessions in the past year. The chart above shows such divergences in blocks since 1987. As you can see, the only time frame that was anywhere near the current abundance of divergences was 1999-2000. Back then, the total first reached the current level of 48 in July 1999. The S&P 500 dropped more than 13% over the next several months, but the bull market didn’t end for more than a year later. Other such spikes in the divergences came just before the crash of 1987 and before a very rocky phase of the market in 1991.
Stretching out the time frame to look at the total number of divergences over a two-year period, then we recently reached 67 days of divergences, Goepfert reports. That was only eclipsed as stocks rallied into March 2000. Uh-oh.
Goepfert observes that it is possible that there is a structural reason for high-yield weakness, such as the liquidity mismatch between ETFs and the underlying bond market. Yet the bottom line is that it is always better for stocks when investors are comfortable holding high-risk bonds. When they don’t, it often signals a looming problem. That’s troubling when you consider how weak the bonds are lately, and the S&P 500 Volatility Index (VIX) is only just barely showing signs of worry. When few are worried, it is very worrisome.
Best wishes,
Jon Markman
