On March 15^th, the U.S. Department of Labor reported that the consumer price index (CPI) in February rose 0.7% — the largest increase in more than three years – and yet somebody forgot to tell the bond market. When inflation increases, the future value of cash (i.e., purchasing power) declines and interest rates should rise as fixed-income investors demand a higher return to compensate for the reduced future purchasing power of their investment principal. Yet, since peaking at 2.06% on March 11^th, the U.S. 10-year bond yield has collapsed to 1.71% — approaching the all-time low of 1.39% hit last year on July 24^th:

Source: Bloomberg

Why are bond yields plummeting while inflation is accelerating? Two reasons:

(1) massive global purchases of bonds by several countries’ central banks; and

(2) weak economic data that has convinced bond investors that the rise in inflation is only temporary.

The U.S. Federal Reserve continues to buy $85 billion per month in Treasury bonds and Mortgage-backed securities. St. Louis Fed bank president James Bullard said on April 3^rd that the Fed is going “full steam ahead” on the purchases with no plans to slow or stop the quantitative easing (QE) anytime soon. A day later on the 4^th, Atlanta Fed bank president Dennis Lockhart and Chicago Fed bank president Charles Evans both said that they don’t expect the Fed’s QE program to slow down until “several months” of 180,000 to 200,000 job growth have occurred. The economy probably won’t achieve “escape velocity” to grow on its own without QE stimulus until 2014.

Across the Pacific, the Bank of Japan (BOJ) announced a massive monetary stimulus that Bloomberg calls:

The biggest, fastest unconventional monetary stimulus any large economy has ever seen. The BOJ’s balance sheet is scheduled to expand by 30 percent of gross domestic product between now and the end of 2014. For comparison, since the U.S. Federal Reserve embarked on QE, its balance sheet has grown by less than 15 percent of GDP – – and it took almost five years, rather than less than two, to do so.

Across the Atlantic, European Central Bank (ECB) President Mario Draghi announced that he was “looking at various instruments” to boost monetary stimulus even further, including “both standard and non-standard measures.” An interest rate cut at the ECB’s May meeting from 0.75% to 0.50% is now widely expected. The Bank of England (BOE) is going beyond cutting interest rates to the radical notion of charging negative interest rates for banks that choose to park money at the BOE. According to a former financial adviser to U.S. President George W. Bush, these coordinated monetary stimulus measures by the world’s four largest central banks (U.S., Japan, England, and the Eurozone) are:

unprecedented on many levels. Not only do you have the most in terms of size of economy or number of central banks, but the effort is a record effort. We’ve never seen such unconventional methods used to create as much inflation as possible.  

Hedge fund manager Kyle Bass predicts that the Bank of Japan won’t limit its bond-buying program simply to domestic bonds, but will reach out and buy foreign bonds as well – in a veiled effort to devalue the Japanese Yen.

Bottom line: This coordinated and massive global bond buying will put such downward pressure on bond prices that interest rates will probably remain exceedingly low for the foreseeable future. Just last week, the yields on government bonds in Japan, France, Belgium and Austria each hit new all-time record lows. According to economist Lacy Hunt, global interest rates will continue to head lower. Historically, a country’s interest rates don’t bottom until 14 years after a financial crisis. Since the 2008 global financial crisis is less than five years old, interest rates may not bottom until 2022 – nine years from now! Hunt’s reasoning is that financial crises are caused by too much debt and debt-deleveraging is a very slow and painful process:

Countries are too heavily indebted, having issued too many bonds and borrowed too much, relative to the size of their economies. With consumers and governments tapped out by high debt burdens and needing to pay down what they owe, there just isn’t the fresh, debt-powered demand to drive the economy upward with any vigor.

What you’ll see in these periods of high indebtedness is you go down to very low interest rates. Look at Japan. Once an economy is laden with debt, it’s almost impossible to return to quick growth rates because central banks aren’t able to stimulate private sector loan growth through monetary policy.

Income Investors Need to Switch From Fixed Income to Dividend Stocks

The current interest-rate environment is so low that it prompted money manager James O’Shaughnessy to pen an article this past January entitled The Most Difficult Environment for Generating Income in 140 Years. O’Shaughnessy argues that the current high level of U.S. government indebtedness (77%) is similar to the 100%-plus U.S. public indebtedness that occurred at the end of World War II. Whenever government debt burdens get too high, the end result is almost always the same: inflation, which hurts fixed-income much worse than stocks because companies can neutralize inflation by raising output prices to absorb higher expenses. O’Shaughnessy notes in the post-WWII 30-year period between 1951 and 1981, U.S. annual inflation rose from near zero to 13.5% in 1980, averaging 4.3% along the way.  During this period, stock returns handily beat inflation whereas intermediate and long-term bond returns lagged behind miserably:

Bond Bear Market: 1951-1981

Source: Morningstar

Since 1790, the U.S. 10-Year Treasury note yield has averaged in excess of 3.5% (slide 13) and rose above 15% in 1981, so today’s yield in the 1.7% range has a long way to go up – which means that prices have a long way to go down. As O’Shaughnessy explains:

For long-term Treasuries, a one percent rise in interest rates would result in an approximate 20 percent price decline, the equivalent of almost seven years worth of income at current yields.

Wow, now that’s what I call extreme interest-rate risk! The lowest-risk investments are those that are currently trading at valuations near their historical long-term average yields – rather than at yields far below average. According to O’Shaughnessy, only “dividend-paying equities” are currently trading near their long-term average yield. Everything else (all forms of fixed income, preferred stock, and REITs) are grossly overvalued based on yield.

Although investors will do okay investing only in U.S. dividend-paying companies, what’s really interesting is the vastly improved performance that can be achieved by adding foreign dividend-paying stocks to the mix. Last week, I discussed the importance of foreign small-cap stock diversification, but there appears to be special benefits associated with foreign dividend-paying stocks.

What makes this so amazing is that U.S. dividend stocks have historically outperformed, so foreign dividend stocks must be true superstars if they have historically outperformed the U.S. dividend-paying outperformers. A double-layer of outperformance!

Our research has shown that dividend yield is an excellent factor for stock selection in the United States, but an exemplary one in the global markets. From 1970 to 2012, an investment in the top decile of dividend-yielding stocks in the global markets would have outperformed their high-yielding U.S. counterparts by 6.3 percent per year (annualized)—a nearly 52 percent greater average annualized return — with a better risk-adjusted return. And in the 481 rolling three-year periods since 1970 global dividend yield outperformed U.S. dividend yield 73 percent of the time.

At the end of 2012, U.S. stocks were more expensive (higher P/E ratios) and lower-yielding than all other global regions except Japan:

Source: O’Shaughnessy Asset Management

Lastly, annualized corporate earnings growth between 2000 and 2011 was much higher outside of the U.S. (10.4%) than in the U.S. (5.0%). The end result is a multitude of reasons to add foreign dividend-paying stocks to your portfolio:

1. Lower valuations
2. Higher earnings growth
3. Higher dividend yields
4. Long-term historical total-return outperformance

Global Dividend Stock Screen

Using my trusty Bloomberg terminal, I screened for small and mid-cap stocks using the following strict criteria:

• Market capitalization between $250 million and $5 billion
• Regular dividend yield of 3% or more (ignored special dividends)
• 5-year, 3-year, and 1-year dividend growth
• 6-year stock price appreciation greater than 15%
• Debt-to-equity ratio 70% or lower

10 Global Small/Mid Caps with 3%-Plus Dividend Yields

Source: Bloomberg

Around the Roadrunner Portfolios

Carbo Ceramics (NYSE: CRR) has received research coverage at Goldman Sachs with an initial price target of $110. Although the initial rating is only “neutral,” a $110 price target means that Goldman sees the stock rising 19.1% over the next 12 months which sounds to me like an outperform call. I think Goldman is being overly cautious in its rating, and concedes that it will upgrade the rating if natural gas prices recover:

A gas recovery could be especially beneficial, as it could re-open certain deeper plays that have historically relied on ceramics.

Ironically, another Goldman analyst already is calling for a natural gas recovery and forecasts natural gas prices to hit $4.50/MMBtu during the second half of 2013 – up from $4.01 currently. Natural gas futures have already risen 20% so far this year. Consequently, I expect Carbo Ceramics to receive several analyst upgrades over the remainder of 2013 as natural gas prices continue to rise.

Smart-money hedge funds are piling into Carbo Ceramics stock, which is a bullish sign.

CommVault Systems (Nasdaq: CVLT) dropped $9 per share at the end of last week (April 3-5) on no company-specific news. Investors have been unnerved by the nuclear war talk coming out of North Korea, as well as weaker-than-expected jobs numbers from the monthly ADP report. According to Investor’s Business Daily, 190 out of 197 industry sectors fell on Wednesday April 3^rd.

Momentum stocks that are richly priced often fall harder than the average stock when the overall stock market declines, but the good news is that they often rebound faster when market indigestion is over. CommVault continues to produce stellar revenue and earnings growth and talk of a takeover continues. Earnings estimates for the next quarter and fiscal year have not been reduced as the industry frenzy for big data continues.

PriceSmart (Nasdaq: PSMT) reported excellent second-quarter financials that beat analyst estimates for both the revenues and earnings. Earnings were up more than 22% year-over-year and revenues were up 11%. Investors cheered the news by bidding up the stock price by 2.7% midday on Wednesday (May 10^th). I continue to be very optimistic about the growth potential for this “Costco of Latin America.”