With QE3, the Fed Just Raised the Risk Investors Most Overlook

Editor’s Note: Futures are pointed higher this morning, indicating that stocks are poised to hit more multi-year highs again today. Yesterday’s Fed announcement of another round of bond buying – affectionately referred to as QE3 – put the market in a bullish mood that should carry over to today.

But how long will the Fed honeymoon last? Andy Crowder has a chart showing that this boost may be short-lived. And Chris Preston was all over the Fed, questioning if the plan is a quantitative easing and how long the bull run will continue. Stay tuned to WyattResearch.com for our latest take on QE3 and its potential impact.

Also, I want to invite you to a free webinar courtesy of my colleague, Andy Crowder. Profit in Any Market Using One High-Probability Trade is a FREE live webinar event that will take place next Wednesday, September 19 at 6:00 ET. Click here to join.

-Jon Lewis, Managing Editor

Risk is about perception. Risk is where we perceive it. 

Investors frequently overestimate risk when ranking financial securities. Bonds are least risky, convertible bonds and preferred stock are more risky than bonds, and common stock is riskier than bonds, convertible bonds, and preferred stock. 

Now as these securities relate to the claim on a company's assets, that's entirely true. The further down the pecking order of a claim on assets, the riskier the security. 

But there is an oversight in the logic: rarely do investors invest for an asset claim. They invest for cash flow and security-price appreciation. 

In other words, loss of purchasing power is the far greater risk and should be the greater concern for investors. Unfortunately, it's a frequently overlooked risk.  

And that's a big, big mistake, because by implementing another round of quantitative easing – colloquially known as QE3 – the Federal Reserve is inflating the money supply at an unprecedented rate. That's inflation in a nutshell, and that's bad news for a lot of investors. 

You see, the payouts on most bonds and preferred stocks are fixed. Purchasing power is lost over time because the money supply is inflated over time. Consumer prices rise, but the investor receives a fixed stream of income that is paid in inflation-depreciated dollars – each unit of currency provides less purchasing power over the years. 

The Fed, in short, is screwing a wide swath of income investors. 

What's more, any price appreciation potential in fixed-income corporate securities is usually only realized by investing in either a distressed potential turnaround – which means investing in a distressed company (like General Motors NYSE: GM) – or by a fall in general interest rates, which appears implausible in today's already rock-bottom rate environment. 

Dividend-growth stocks issued by sound companies with strong brand names are the best hedges against loss of purchasing power.  Two of the stronger brand-name dividend growers – McDonald's (NYSE: MCD) and McCormick & Company (NYSE: MKC) – reside in the High Yield Wealth portfolio. 

Both McDonald's and McCormick have admirably maintained and increased their investors' purchasing power through the years. 

McDonald's Dividend Payout

An investor in McDonald's would have received nearly $14.40 in dividends per share over the past 20 years.  If the investor purchased a hundred shares of McDonald's, he would have received nearly $1,440 in dividends on that initial $800 investment through 2011. 

Of course, it's also worth mentioning the nearly 10-fold price appreciation on that initial investment. As cash flow goes, so too generally goes the share price. 

McCormick & Company investors also experienced a similar increase in wealth over the same period.

McCormick & Co. Dividend Payout

Since 1992, McCormick investors would have accumulated $10.80 in dividends per share. A hundred shares purchased in 1992 would have generated $1,080 in cash flow, and a nearly six-fold increase in price per share. 

How would a bond investor have fared? In 1992, we were in a recession during which triple-A corporate bonds offered an 8% coupon. If a $1,000 30-year fixed-rate bond were purchased at that coupon, an investor would have received $1,600 on his investment through 2011. His investment would have doubled to a market value of around $2,000 today with nearly a decade remaining of $80 annual coupon payments because of today's historic low rates.

To be sure, this bond wasn't a poor investment in 1992. But it just wasn't quite as good (when accounting for price appreciation) as dividend growth. Moreover, good luck finding a triple-A corporate bond that yields 8% today. The going rate is closer to 3.5%.

And let's not forget taxes. That $80 annual interest payment is taxed at the investor's marginal income tax rate, not the lower dividend rate that currently prevails. 

The bottom line is that I see dividend growth as being as good a strategy today as it was 20 years ago. 

If both McDonald's and McCormick increase their dividend 9% annually over the next 10 years – and that's entirely reasonable – McDonald's investors will receive annual dividends of $6 per share at the end of the period. McCormick investors will receive $2.70 per share a decade from now.  I would also expect both companies' share price to at least double by 2012. 

It's also worth noting that both McDonald's and McCormick weren't high-yield investments in 1992.  But over time, thanks to dividend growth, they became high-yield investments in their own right to investors who would have held their shares. 

In today's low interest rate, Federal Reserve manipulated environment, dividend growth stocks of quality companies offer far better protection against the risk of purchasing-power loss than putatively “safer” bond and other fixed-income alternatives.