The Next Big Crisis

Kyle is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The markets are getting close to their all-time highs and people are already asking, “Is another crash coming?” The 2007-2009 market decline devastated portfolios and crushed nest eggs. To add to the misery, many sold off all of their stock holdings in the lows of 2009 in an attempt to stop the bleeding, only to see the markets come full circle and climb again. Those who were mostly in treasury notes saw their portfolios rise as interest rates continued to fall. With the markets reaching their old peaks, are those predicting the next crisis really looking in the right place?

As I mentioned above, treasury notes appreciated in value as the stock market had the carpet yanked out from underneath it. In order to stimulate the economy and stop the bleeding, the Federal Reserve initiated a number of programs that drove interest rates to the lowest level seen in many decades. Today, a ten year treasury note yields a mere 1.86%. To see where this stands in comparison to historical yields, see the chart below.

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The majority of people understand, in an overall sense, how money is made in stocks: an individual purchases shares of a company and those shares will, in the long run, increase or decrease in relation to the performance of the company. The situation, at least I must assume, is different with treasuries, else people would not buy them at the rate they are today. With a treasury note, the underlying value increases or decreases with the movement of interest rates. If, for example, you have a 5% yielding treasury note and interest rates fall to 4%, your note is now more valuable than that which can be purchased today because it carries a higher yield. The opposite is true when rates begin to increase. If you buy treasuries today, you are either accepting a return of 1.86% annually for the next ten years or you believe rates will continue to decrease. Unfortunately, there are two things running against you: history and inflation. If you again look at the chart above, history shows that we are already at extremely low interest rates. In addition to that, the long-term inflation rate has averaged 3% per year. With a yield of 1.86%, you would be losing 1.14% of your purchasing power each year.

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What really worries me is the “Lollapalooza” effect we may experience in the near future. This effect occurs when multiple forces start moving in the same direction, leading to either incredible or catastrophic results. The forces I see moving in the same direction involve a particular U.S. demographic, common financial advice, incredible fear of the stock market, and extremely low interest rate on treasury notes and bonds. The combination of these forces may soon unleash a perfect storm on the very people who are the least able to bear its wrath.

According to PewResearch, Jan. 1, 2011, marked the date of the first Baby Boomers reaching retirement age. Every day for the next 17 years, approximately 10,000 Boomers will either enter retirement or reach retirement age. As has been well publicized by financial planners, those entering retirement should be shifting their assets from what some consider more risky investments (stocks) to what are typically considered safer investments (treasuries/bonds). With many Boomers frightened of losing more of their hard-earned money in the stock market, this seemed like wise advice. The fear of loss due to the 2007-2009 market crash has driven hundreds of billions of dollars out of equities and into treasuries and bond funds. With the understanding of how bond prices move and the extremely low interest rate environment we are currently in, you can see that the next crisis may not be in stocks!

My greatest fear is that those who worked hard all of their lives and who saw their savings cut in half by a particularly nasty downturn will end up being thrashed again by following advice that may have made sense with higher yielding treasuries. I fear that those who seek to find comfort and safety in fixed income will find nothing but danger and loss. I fear for what may happen on a societal and governmental level if a huge portion of our population does not have the means to support themselves in their old age. Alas, there is hope, but time is running out.

Rather than be fearful of the stock market, people should embrace it for what it is. Benjamin Graham, the father of value investing, described the market as a manic depressed person who is willing to either buy or sell a portion of a business every day. If he is in a jubilant mood and offers to buy your stake for a rich price, you can easily accept his offer and he will not be upset with you, even if the price drops. If he is in a panicky mood and is willing to part with a business at a fire sale price, you can gladly accept with the knowledge that he will be in better moods in the future. When one looks at the market in this manner, it is much easier to withstand the everyday ups and downs.

Now that I have pointed out the potential danger in investing in treasuries today, you may be thinking, “Well, where the heck do I put my money?” The answer will differ from situation to situation, but there are a number of excellent companies that have stood the test of time and have dividend yields greater than those of treasuries. Coca-Cola (NYSE: KO) is a solid choice, as the company sells a product consumed everyday world-wide. Along the same lines, PepsiCo (NYSE: PEP) sells a range of beverage products, in addition to a diverse line of snack foods. Johnson & Johnson (NYSE: JNJ) and its well-known medical brands allow it to earn above-average profits, which can then be passed on to shareholders through dividends. Finally, Procter & Gamble (NYSE: PG) and its brand-name consumer staples keep customers coming back for its products, no matter what the economic environment. As you can see below, these companies not only have dividend yields that are higher than those of 10-year treasuries, they continually increase their dividends!

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data by YCharts

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data by YCharts

Simply picking a company because its dividend yield is higher than U.S. treasuries would be foolish (little “f” is bad). Picking a company because it has great products, pricing power, and a great dividend to boot, now that is what I would call Foolish (big “F” this time, that’s good!). If you want to find companies with great products and pricing power, look no further than Coca-Cola and PepsiCo. These two companies control what can easily be described as a duopoly, with Coke taking the number one and number two spots for most popular soda (Coca-Cola Classic and Diet Coke), and PepsiCo taking third with its Pepsi line. In addition to its soft drink line, PepsiCo boasts a large portfolio of top brand names in the snack-food industry (mmm, Sunchips). With great products and industry leading brands, these two companies have a massive amount of pricing power. With a low dollar figure price for their products, these two behemoths can increase prices by 10% without their consumers grabbing their pitchforks and marching on Coke/Pepsi HQ. Unlike companies which sell higher priced items, Coke's/Pepsi’s price increases would amount to an additional nickel or dime, something most consumers would hardly notice.

While the companies above contribute to our growing waistlines, Johnson & Johnson and Procter & Gamble manufacture products that we need in our everyday lives, products we typically cannot do without. For example, the toothpaste you use to brush your teeth after drinking a Coke or eating some Fritos is very likely a P&G product (Crest). If brushing teeth isn’t your thing, the razor you use in the morning may also bear a logo owned by P&G (Gillette). Every had a hip replaced? If so, that new piece of hardware you’re sporting is probably stamped with a J&J-owned brand. When a child has the flu, many parents turn to Tylenol, a J&J consumer product. What do all these products have in common? We use them every day and usually do not even realize it! The J&J and P&G brands are highly recognizable and have millions of loyal customers. Great brands and a loyal customer base signal pricing power.

In inflationary environments, the companies I mentioned will fare far better than the treasury notes being gobbled up today. Companies with strong brands and pricing power are able to pass increased costs on to consumers and maintain profit margins. If my fears are realized and the Boomers don’t see the danger surrounding them, I can’t help but wonder if we will see another recession. In that scenario, many will start to cut back spending or delay purchases until a later time. Luckily for the companies above, most people focus on cutting higher-cost goods, rather than the day-to-day essentials.

Doom and gloom is not my intention with this article. The inspiration for this topic has mostly come from interactions with others who simply did not understand how interest rates affected treasuries and bonds, yet continue to plow money into them. Financial security brings a peace that cannot be quantified. I can only hope that after reading the information written here, you have a better understanding on what the future may hold. Good luck!

RoyalScribe owns shares of Coca-Cola. The Motley Fool recommends Coca-Cola, Johnson & Johnson, PepsiCo, and Procter & Gamble. The Motley Fool owns shares of Johnson & Johnson and PepsiCo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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