Please refer to Important Disclosure Information at the end of this research note.
The S&P 500 (i.e., the “market”) is now down a little more than 5% this year, excluding dividends. The market was actually up for the week - in your face, Volatility!
If you’re an income investor owning Master Limited Partnerships (MLPs) you probably had more excitement this week than you cared for (more on this below).
With the benchmark 10-year Treasury note still yielding 2%, we remain comfortable with a principal-protected 5%+ dividend yield income portfolio.
Are We In a Bear Market?
In our last weekly report, we asked and Forbes answered, running an article, titled “Are Stocks Headed for a Bear Market?”
Seven investment strategists (including us) shared their views. Our views are essentially that we’ve reached a fork in the road. Monetary policy (i.e., QE) has run its limits and now we need something else, possibly fiscal policy, to drive corporate earnings. If we get it, then the markets will grow into its current valuation. If not, we may be looking at a very expensive market.
With the "wisdom of crowds," the market is good at assimilating all publicly available information, but it cannot cope with high uncertainty.
Understanding the U.S. Unemployment Rate
There are few metrics that are as polarizing as the U.S. unemployment rate.
The optimists point to the low 5.1% unemployment rate as a sign that the economy is improving. The pessimists claim that the unemployment rate is not a good economic barometer.
To understand who’s right, let’s see how the rate is calculated.
According to the BLS’s household survey, the civilian labor force was 156.715 million, down 350,000 from the prior month. The civilian labor force comprised 148.800 million employed and 7.915 million unemployed.
Those not in the labor force was 94.610 million, up 579,000 from the previous month.
The unemployment rate is calculated as follows: 7.915 / (148.800+7.915) equals 5.1%.
It’s worth noting that both the employed and the unemployed decreased in September but those that left the labor force (perhaps because they couldn’t find a job) increased in September.
So the unemployment rate benefited from a lower number of unemployed (positive) and a higher number of civilians who left the labor force (negative).
So who’s right, the optimists or the pessimists?
Master Limited Partnerships (MLPs)
The Alerian MLP index is down 23% for the year, and even the 8.8% dividend yield doesn’t cover the loss of principal. Barron’s stirred up a hornet’s nest last week with a series on MLPs which can be found here, here, and here.
If you own MLPs, I highly recommend reading them. If you don’t own MLPs they're still worth reading because they raise important questions about how market participants process the same data.
While MLPs at today’s prices may represent attractive value, we don’t own any in our Income Portfolio because frankly we don’t understand them and we can't explain them to a six year old.
If you do own MLPs or are planning to own some, it may be worth asking these questions:
- Is the dividend safe? Is it covered by both current and future distributable cash flows? What is the average contract duration? If its 10 years on “average” does it mean there are some contracts that are much shorter leading to an unexpected drop in cash flows and potentially stressing the dividend?
- Is your principal safe? If the yield increased to 15% from 10% due to a fall in share price what does it mean for your investment? Your principal is now down 33% and you may need 3.3 years of dividend payments just to recoup the loss of principal.
- What is the counterparty risk? Even if the MLP does not take commodity price risk (such as oil price risk), its customers may. Will their customers be able to honor the contracts? Could the customers force a contract renegotiation cutting payments and impacting the dividend?
Important Disclosure Information:
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Burr Capital LLC), or any non-investment related content, made reference to directly or indirectly in this research will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this research serves as the receipt of, or as a substitute for, personalized investment advice from Burr Capital LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Burr Capital LLC is neither a law firm nor a certified public accounting firm and no portion of the research content should be construed as legal or accounting advice. A copy of Burr Capital LLC’s current written disclosure statement discussing our advisory services and fees is available for review upon request.