Income is vital for investors right now, says Eric Roseman. He says investors should begin to accumulate long-term positions in “busted” credit markets. Investment-grade corporate debt currently offers great yields and, in some cases, is government-guaranteed. These bonds may not have bottomed out yet, but now is the perfect time for value investors to test the waters.

This from Sovereign Society:

“This aging stock bull market is looking increasingly like a scarred prizefighter after winning too many championships. Indeed, the market is looking increasingly fragile, bruised and battered since the bear market low in October 2002.”

In January 2008 I made the above observation about stocks as the market was coming undone. Of course, almost a year later the stock market has collapsed with stocks likely to post their worst calendar year of performance since 1931. Over $10 trillion dollars of global stock market values have been wiped-out in 2008.

So is it time to start looking at stocks again? Despite several bottoms over the last 14 months, can we expect stocks to finally form a meaningful rally? From their lows on November 20, stocks have now gained 10%.

Indicators Flash “Buy”

Many market indicators I track are flashing “Buy” since late November. These include high institutional and hedge fund cash levels, extremely bearish investment advisor sentiment readings, big dividend yields for many global markets in excess of benchmark ten-year government bond yields, and a rash of hedge fund closures and failures.

Also, individual investors have been dumping stock funds like crazy since July with record net outflows over the last five months and the VIX Index (CBOE Volatility Index) remaining highly elevated amid total fear in the market.

Stock market valuations, though not dirt-cheap are certainly looking far more attractive compared to just 12 months ago.
Valuations and dividend yields, which can typically point to either an over-extended or undervalued market, now show fair value for U.S. stocks and high value for European, Asian and emerging market equities following even bigger declines for these markets.

Stocks in Europe yield 5.9% and in Japan the TOPIX (the country’s broadest stock index) pays a 3% dividend…the highest in more than 28 years. Indeed, compared to stocks, government bonds are richly valued and pay the lowest yields in years and in some cases, decades.

Explosive Bear Market Rally Coming

I’m certainly not bullish by any means. The long-term implications of mass government intervention, widespread regulation and control of several important industries (including finance) won’t encourage bold risk-taking for a long time. Credit markets are grudgingly healing, banks largely won’t lend and TARP and TALF-sponsored government programs are taking too long to filter through the economy.

There is absolutely nothing in the cards to suggest a new bull market is on the horizon.

But like the 1930s, the stock market can post a major short-term reversal and shock the bears with big double or even triple-digit gains. It’s hard to say what might trigger a major reversal. Obama’s inauguration in January, lower LIBOR and inter-bank lending rates or possibly a weaker Japanese yen might offer such a catalyst.

The last credit crisis of this magnitude occurred in the 1930s. Judging by trends during that tumultuous era, stocks can indeed post some huge gains even in a bear market. For example, from its lowest point in June 1932, the Dow Jones Industrials surged more than 162% twelve months later. But by 1937, the Dow began crashing again, plummeting 55% and losing another 28% in 1938 before finally bottoming in 1942.

After crashing more than 45% off the October 2007 all-time highs, U.S. stocks might be attempting to finally muster a bottom. Any rally, however significant, should be viewed in the context of a secular bear market; the badly shattered economy is in no condition to build on a sustainable long-term rally like the 1990s or 1980s.

New Market Leadership: Go for Credit

Ahead of the upcoming bear market rally investors will have to find new leadership. It’s highly unlikely that energy stocks or emerging markets will lead any recovery, however short-lived. Instead of riding a frantically erratic stock market that continues to trade at near-record volatility levels, I would encourage investors to begin accumulating long-term positions in busted credit markets.

The epicentre of this financial crash lies in the distressed credit market – and that’s where investors should focus their buying strategies. Income is vital right now.

The entire spectrum of non-Treasury securities has been crushed since September, including investment-grade corporate bonds, convertible bonds, mortgage-backed agency debt and TIPs or Treasury-Inflation-Protected Securities. Emerging market bonds, municipal bonds and junk debt or high-yield bonds have been slammed even harder. But they should still be avoided as defaults, failed auctions and currency issues plague these credits.

But several other areas of credit look highly compelling.

Investment-grade bonds, for example, plunged to their lowest levels since 1981 in September and yield 8.38%, according to the Barclays Capital U.S. Corporate Index.

I don’t know about you, but a 7-8% yield today looks mighty appealing. And looking back at the bear market rallies of the 30’s, it’s clear that most investors won’t get off the bus before equities begin crashing again. Despite the seemingly terrific trading opportunity in stocks, it’s still just too volatile out there.

High-grade corporate debt at least offers the investor a combination of above-average income, the spectre of capital gains at these low prices and in some cases, implicit government guarantees on bank debt and agency bonds, which still yield about 5.5% or more compared to expensive Treasuries.

Nobody can claim that corporate bonds, agency debt or convertible bonds have truly bottomed after more than 16 months of utter panic and several crashes. Yet as value investors, this is precisely the time to start purchasing these distressed securities.

Doing so will at least allow conservative investors to ride out a harsh cycle, instead of buying the top during a bear market rally and getting burned as stocks crash lower. Best of all, those juicy yields and bombed-out prices should eventually translate into impressive double-digit gains for investors…regardless of where stocks trade.

Source: Focus on Busted Credits and High Income in 2009