I would love to be an unabashed stock market bull right now.

It is very easy to be a market bull. People love a more optimistic message. If you are a market bull, you can have conversations about artificial intelligence, renewable energy, electric vehicles, and all that other exciting stuff.

Bulls promote the idea of a market rally that instills a belief that folks maybe that 401(k) will finally rally back to levels that give you the hope of retiring someday.

The truth is that I am not excited about the broader market’s current levels.

Here’s why – and what you should do about it…

I read the bullish headlines like the ones we saw last week, and Atlanta Federal Reserve Governor Raphael Bostic’s seemingly bullish remarks. He said that the Fed might be able to stop raising rates sometime this summer. He suggested that the Fed may only increase rates by 25 basis points at the next meeting. But a 25-basis point hike has been baked in for weeks; any higher projections were an outlier.

Talk about hanging your hat on a thin branch.

The same day that market bulls selectively listened to Bostic’s remarks, two other Fed officials issued statements reinforcing the idea of higher interest rates for longer than most expected. Fed Governor Christopher Waller had one of the more interesting speeches last week for a couple of reasons: first, his scheduled video talk with the Mid-Size Bank Coalition of America had to be canceled because one of the participants porn-bombed the presentation—that may have been a first in the history of presentations by a sitting Governor of the Federal Reserve!

The second reason that the talk was interesting is the fact that Waller admitted that he no longer believes the Fed has made any real progress in its fight against inflation. Waller pointed out that despite aggressive rate hikes and a gradual decline in the Fed’s balance sheet, the labor market is still pretty strong. The same day Waller made those remarks, new unemployment claims declined for the seventh week in a row.

It would be nice to be in a strong bull market, but the fact is that higher rates are bad for equity prices. Almost every valuation model for equity valuations has interest rates as a significant input, and higher rates equal lower valuations.

That stark fact makes it tough to be a raging bull, especially when you consider current valuation levels.

So what should investors be doing right now?

I continue to favor pockets of the market that no one else thinks about very often. High-yielding smaller banks with low valuation ratios are priced for massive returns. Banks that trade below tangible book value will likely be takeover targets as consolidation continues in the industry.

I love special situations, but we are in a bit of a dry spell in that market segment at the moment.

Energy infrastructure and fixed income also appear much more attractive to me than the stock indexes and well-known blue chips at current levels.

One corner of the market that I am getting very interested in is exchange-traded debt and select preferred stocks. Bonds and preferred stocks traded on leading exchanges offer attractive yields right now, and many of them are priced at a healthy discount to par value.

At some point in 2024, the Fed will lower rates to deal with the recession that its actions will likely have caused. I do not care much about the eventual maturity of these securities. I want to collect the coupon and sell them when they rally back to near par at some point in the future.

I accept that the odds are that the securities will trade lower before they trade higher. And in fact, I may buy more if they go low enough.

The exchange-traded bonds issued by Customers Bancorp Inc. (CUBI) are a favorite right now. Customers Bancorp is a bank that has used technology to expand out of its home market. It has several very profitable niche lending markets that will help drive profit growth for many years.

The bank issued 5.375% subordinated notes due 12/30/2034 that trade on the New York Stock Exchange with the symbol CUBB. The bonds have a $20 par value and are callable at $25 in 2029. Currently, the bonds are trading around $22, giving them a current yield of about 6%.

The bonds trade in lockstep with interest rate moves, so I expect to see even more attractive pricing sometime this summer as the Fed continues to hike rates.

I will take a rate of 6% or more with the chance of an additional 12%–15% rally at some point over trying to call a bottom in stock indexes at more than 20 times earnings every day.

The Customers Bancorp bonds are just one example of exchange trade securities with regular payments, double-digit upside potential, and a high margin of safety.

We will explore a few more over the next week.

— Tim Melvin

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Source: Investors Alley