Today, the market is in “risk on” mode. The Volatility Index (the “VIX”), the market’s fear gauge, is low. According to Bloomberg, hedge funds are the most leveraged since 2008 and net long since 2004.

While this high leverage, apathy, and bullishness could point to a short-term correction, we’re long-term bullish (thanks to the Global Bernanke Asset Bubble – a global increase of asset prices thanks to central banks’ money printing).

[ad#Google Adsense 336×280-IA]One effect of “risk on” – and the lack of yield created by easy-money policies – is the outperformance of high-yield (aka junk) bonds…

Their average yield fell below 6% for the first time in history, based on the Bank of America Merrill Lynch High Yield Master II Index.

So far this year, investors in U.S. junk bonds have made around 1.3%, according to Barclays indexes.

Meanwhile, investment-grade bonds (which sport lower yields) are down about 0.2%.

The biggest gains in junk bonds were in the lowest-quality paper… triple-C-rated debt, which yields an average of 8.2%, has returned nearly 2% this year.

Investors are searching for yield (inflows into junk-bond funds reached their highest level since September [two week ago]). But it will end badly. Massive debt issuance and money printing will inevitably lead to inflation, which will wipe out the value of your yield. We’re happy to hold high-quality stocks during inflation. But inflation crushes bonds… especially the riskiest ones.

Even without inflation, most bonds are simply too expensive today. (Remember… bond prices and yields move in opposite directions. So as yields shrink, the bond prices rise.) The 10-year Treasury is yielding about 1.83%. Even modest inflation will obliterate that return. Moody’s Triple-A bond yield forecast for February is 3.98%. Current inflation cuts that return in half, and an uptick in inflation would erase it. (Not to mention, it’s fully taxable.) Junk bonds as a group are not even yielding 7%, using Barclays High Yield Bond Fund (JNK) as a proxy. That’s roughly 5% over Treasurys. Historically, junk-bond spreads have been most attractive above 8% over Treasurys.

It’s not just bonds, either. All kinds of income-generating securities are too expensive these days. Many REITs yield less than 5%. The S&P 500 dividend yield is around 2%, and hasn’t been above 6% since the early 1980s.

Investors simply refuse to learn about risk. They fail to appreciate the simple, powerful truth that risk is highly dependent on the price paid for a given investment. Most members of the investing herd never stop to think about what this really means…

It means you can lose 90% of your money paying too much for “safe, high-quality” blue-chip stocks… or make 20 times your money over the long term buying the lowest-quality debt securities.

Those aren’t hypothetical results. They really happened. According to Oaktree Capital Chairman Howard Marks’ latest memo, if you bought the “Nifty Fifty” blue-chip stocks – 50 large-cap stocks considered “buy and hold” growth stocks – in the late 1960s and held on, you eventually found yourself holding a loss as great as 90%. And if you bought a high-yield bond index at the end of 1979 and are still holding, you’ve made more than 20 times your money today… without ever being in the red.

I have often stressed buying only high-quality businesses. I still think it’s true that the great thundering herd of investors should follow the advice of the father of value investing, Ben Graham, and never put money into a low-grade enterprise. That’s one of the reasons I’ve urged subscribers to load up on World Dominating Dividend Growers the past few years. They’re the kind of “high-grade enterprises” most investors should focus their holdings on.

But without the most important reason of all – their cheap valuations – you would never have heard a peep out of me about them. During the past few years, many WDDGs were priced cheap enough to provide good returns. Price is always the final arbiter for me when making any recommendation. For example, I wrote volumes for six years about Wal-Mart (WMT) when it was in the high $40s and low $50s… but I’ve been mum about the stock since it soared into the high $60s and mid $70s last year (except to brag a little, of course).

The ultimate determinant of risk is not asset quality. It’s the price you pay. No asset is so safe it can’t become too expensive and risky to own. And likewise, almost any asset is safe at a cheap enough price.

To understand the relationship between risk and asset prices, remember one sentence: Price and risk go up and down together. When prices rise, so does risk. When prices fall, risk falls, too.

The failure to understand the direct correlation between price and risk is why most investors lose money when they buy and sell stocks and bonds. Most people behave as though risk rises when prices fall, so the more prices fall, the more scared investors become. The more prices rise, the more euphoric and greedy investors become. They’ve got it totally backwards. At market extremes, the paradox is at its peak. At market tops and bottoms, the herd becomes a great mass of moths flying at full speed into a giant flame.

The inability to understand investment risk will never change for most people. It’s a good thing, too. If human beings were any good at learning from their mistakes, it might put us out of business.

Regards,

Dan Ferris

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Source: The Growth Stock Wire