The Downside of an Up Market

The real-money Inflation Protected Income Growth portfolio finished another stellar week, gaining more than 1.3% since last week's update. Overall, the portfolio's total return stands at 28.9% since its December 2012 launch, which in an ordinary market would be a phenomenal accomplishment.

In this market, however, it's just about average. The S&P 500 is up roughly 27.8% since the portfolio launched, and when you include dividends, the index is actually outpacing the iPIG portfolio's returns. While there's a lot to celebrate with returns that high, there's a lot to worry about, too -- including the high probability that the good times won't last much longer.

What's it really worth?
The key problem with such a rapidly rising market is valuation. The intrinsic value of each company is based on its ability to generate cash for shareholders in the future. When a stock price rises significantly faster than the company's cash-generating abilities, investors essentially have to accept lower rates of potential future return on their investments. If stocks get priced high enough, a bubble can form in which, when it bursts, investors' real returns can actually be negative for many years.

Whether or not a bubble is currently forming, the reality is that the recent gains in the market have made it difficult to find reasonable values among solid companies. It has gotten so crazy, for instance, that new investors in iPIG pick NV Energy (NYSE: NVE) are essentially signing up to accept a virtually guaranteed capital loss on their investment.

While NV Energy, Nevada's regulated electric-generator, has been a fine pick for the iPIG portfolio, the company is scheduled to be bought out for less than its current market price. That makes today's market price almost a crazy price to pay, and only the fact that NV Energy has maintained its dividend keeps it from being completely irrational.

Thank goodness for those dividends
Dividends are a key part of what makes a company worth owning in the iPIG portfolio. The beauty of a dividend is that it gets paid based on how the company is performing, rather than what the market happens to think at the moment. Every company needs to pay dividends and have some track record of increasing dividends before being selected. This past week was a strong one on the dividend front, as three companies in this portfolio issued payouts.

On Tuesday, industrial gases and chemicals company Air Products & Chemicals (APD -0.28%) handed its owners $0.71 per share. That payment gave the iPIG portfolio $12.07 for the 17 shares of Air Products & Chemicals stock that it owns. The payment was the third dividend at that level from the company. If it follows past practices, Air Products & Chemicals will pay one more dividend at that rate before potentially increasing its distribution. 

On Friday, toy titan Hasbro (HAS 4.01%) handed owners $0.40 per share. Thanks to that payment, the iPIG portfolio picked up $17.20 for the 43 shares of Hasbro the portfolio owns. Like Air Products and Chemicals', Hasbro's dividend marks the company's third payment at that level. Hasbro's ability to continue raising its dividend will depend on this quarter's holiday sales, but that's par for the course in the toy business.

Also on Friday, pipeline giant Kinder Morgan (KMI -0.32%) paid out $0.41 per share. As owner of 42 Kinder Morgan shares, the iPIG portfolio picked up $17.22. Kinder Morgan has been raising its dividend a small amount virtually every quarter since resuming its life as a public company, but its dividend is at greater risk than those of most other stocks in the iPIG portfolio.

Kinder Morgan has a complicated corporate structure, and the security held by the iPIG portfolio owns the general partner stake in the business. In large part because of that structure, Kinder Morgan pays its dividends based on its cash flow, rather than accounting earnings, and its dividends often exceed its earnings. So long as the pipelines the company runs continue to operate effectively, that sort of payment can be kept up, but it does leave very little room for error.

Total returns rely on both dividends and gains
While the iPIG portfolio is designed around dividends, the gains it has seen have provided a significant share of its total returns. The market has been incredibly helpful, but it's a trend that likely won't last. But as long as there are opportunities to pay reasonable prices to buy companies that pay and increase their dividends on a regular basis, there will be an opportunity for the iPIG portfolio to operate. The table below shows a snapshot of the portfolio, as of Nov. 15, 2013:

Data from the iPIG portfolio brokerage account as of Nov. 15, 2013.

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