With stocks up 25%-30% this year to all-time highs, a significant rally next year could be asking for too much. Corporate profit margins are near all-time highs, suggesting that mean-reversion in this cyclical metric could be at hand. Importantly, the percentage of investors that are bearish is near historical lows, typically a robust contrarian indicator. Therefore, I see multiple scenarios in which common stocks trade sideways in the coming year.
How likely is it for markets to rally again next year?
Pundits have been surprised at the strong rally in stocks this year. Most agree that the reason for the spike in stocks is the Fed's continued quantitative easing, to the tune of $85 billion per month. The exact mechanisms by which this liquidity injection fundamentally supports the stock market is unclear. However, it has proven to be a strong factor in giving investors the courage to follow the bullish herd.
If stocks begin to run out of steam, perhaps due to a continued lackluster economy, weak retail sales or a diminished margins, interest rates would remain ultra-low for an extended period. While low interest rates have fueled the market this year, will that be enough to prolong the party indefinitely? Due to high distribution yields, there's a scenario in which master limited partnerships, or MLPs, continue to grind higher long after stocks stall.
The search for yield could kick into high gear
This year there's plenty of evidence of investors reaching for yield and increased risk-taking behavior in asset classes like leveraged loans, sovereign debt, and high yield bonds. Yields on many common stocks have fallen dramatically as well. Yet, select MLPs still offer double digit yields that are increasingly attractive on a relative basis. For example, units of Natural Resource Partners (NYSE:NRP) are yielding 11%. Even if this company's financial metrics fail to improve next year, 11% is 2-4 times the yield of alternative investments.
Therefore, in an environment where investors recognize that stocks may not rally next year, an ever growing number will be hungry for yield. By the end of 2014, MLPs like Natural Resource Partners could be yielding far less than 11% as investors eagerly buy units. If the required hurdle rate (yield) to own Natural Resource Partners is 10%, 9%, 8%, or 7%, then the one year total return on a unit of would be 23%, 35%, 50% or 70%, respectively. These prospective outcomes are not as aggressive as one might think. If at the end of next year interest rates are still artificially low, a desperate search for yield could reasonably drive hurdle rates on MLP's significantly lower and unit prices higher.
Alliance Resource Partners remains very attractive as well
Another MLP that I've liked for some time is Alliance Resource Partners (NASDAQ:ARLP). Unlike most energy-related MLPs, Alliance is an actual producer of a commodity, namely thermal coal used in coal-fired power plants to generate electricity. Alliance has proven to be the premier coal producer in the U.S., vastly outperforming peers like Arch Coal (NYSE:ACI), Peabody Energy (NYSE:BTU), and Alpha Natural Resources (NYSE:ANR), each down 35%-45% from 52-week highs. By comparison, Alliance is within 5% of its 52-week high.
Interestingly, Arch, Peabody and Alpha have each staged impressive rallies from their respective 52-week lows, i.e. they were much lower at the beginning of 2013. However, the rally in coal stocks may be nearing an end as underlying coal prices have stopped moving up and utility stockpiles remain elevated. Further, this year several planned west coast and Gulf of Mexico port facility projects have been canceled or severely delayed. This will have a long-lasting negative impact on Powder River Basin coal pricing.
Despite Alliance's strong relative outperformance, it still offers a juicy yield of 6.5% (based on a quarterly distribution growth rate of 2% in 2014). If the hurdle rate to own Alliance Resource Partners were to fall to 5%, still in the middle of the pack of MLP yields, the total one-year return would be 36%. I have to believe that a possible 36% return in 2014 would be a spectacular outcome. Importantly, an investment in Alliance is not a desperate stretch for yield as it has the best margins, lowest debt leverage, and strong earnings visibility for both 2014 and 2015. The company operates in the top coal basin in the country and has industry-low costs.
In a scenario of ultra-low interest rates that last longer than expected, a natural progression from this year's melt up in stocks could be that high-yielding investments become significantly more sought after. As stocks possibly languish next year or even decline, investments with high current yields could still flourish. Both Natural Resource Partners and Alliance Resource Partners would greatly benefit from continued, and perhaps, accelerated yield compression in asset classes.
Peter Epstein owns shares of Alpha Natural Resources, Alliance Resource Partners, L.P., and Natural Resource Partners LP. The Motley Fool recommends Alliance Resource Partners, L.P.. 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.