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Classic Investment Strategies as An Aging Bull Runs Up Against Fed Tapering
Posted by: David G. Dietze, JD, CFA, CFP (IP Logged)
Date: September 16, 2013 09:46AM

Face it! With the market up over 150% since the March 2009 bottom, nearly 20% this year alone, anyone throwing new money at this market is, well, a bit late to the party. Valuations, while not expensive, are hardly at bargain levels, as corporations’ last quarterly earnings were up less than 5%, lagging behind the double digit advance in their stock prices.

Moreover, stocks now must confront rising interest rates. As recently as early May, stocks seemed like a no brainer; after all, the market’s 2.1% dividend yield easily trumped the 1.6% on the ten year Treasury. It was much easier to bet on stocks for the next ten years versus Treasuries with that kind of head start.

Investors now have to deal with one of the sharpest interest rate advances in years, with the ten year Treasury now about 3%, easily trumping the S&P’s payout. What’s more, one of the most anxiously awaited Federal Reserve meetings of the year is slated for next week, when most economists predict the implementation of the much dreaded taper – a slowing of the monthly bond purchases by our central bank. That’s a movement to less liquidity, not more, and can hardly be seen as helpful to holding down interest rates.

Meanwhile, a whole litany of other hurdles confronts the market. Showdown at the Washington budget corral has to rank right up there; will Congress accede to a higher debt limit or will the government shut down first? Time for consideration is short with our credit cap expected to be reached in October, especially as we are diverted by issues like Syria.

Bottom line, should you commit new money to this market now, and if you are invested should you stay that way? After all, no one went broke taking a profit!

In A Nutshell

With stock prices up but bond prices down (and thus their yields up), while corporate earnings growth remains challenged, investors must become far more selective. Moving to the sidelines doesn’t make sense for long term investors; no one really knows when the current bull will end and the next one start, plus you’d need a microscope to see the yield now available on cash. Inflation will erode that cash stash, too.

To become more selective, consider classic investment strategies. Strive for quality investments, companies that dominate their markets, and undoubtedly will be around through many market cycles. But, don’t forget valuations, as measured in a number of ways. Eschew the overpriced, the overhyped.

Buy the Laggards

A sound strategy is buying investments that have failed to keep pace with the market leaders. Why does that work? Reversion to the mean is one reason. As the hot stocks get more expensive, profits are taken, with the proceeds rotated into cheaper areas of the market.

Consider: If you had bought the S&P 500 ten years ago you’d be up 102% cumulatively by June 30 of this year. However, if instead you had spread you money out equally among the nine sectors of the S&P (financials, health care, etc.), and quarterly rebalanced, subtracting from the winning sectors and redeploying into the laggards, you would enjoy a portfolio a third bigger, up 133%.

Rebalancing into laggards also reduces your risk. You cut your exposure to sector that’s been the hottest and thus likely to be the priciest.

Buying laggard sectors represents less risk than buying laggard stocks. Sectors rebound, but stocks sometimes don’t. You can excuse a lagging stock in a lagging sector because you know it’s facing headwinds external to the company. This helps you rule out a company specific problem.

So, what are the laggards, and how do you play them? Energy stocks have underperformed the broader market four of the last five full years, with an annual average return of negative 0.65% for the five years ending June 30 versus 6.93% for the broader S&P 500.

Appropriate investment vehicles could include an exchange traded fund targeting just the energy stocks of the S&P 500, like the Energy Select Sector SPDR (XLE). Morningstar rates this five star, its highest category, citing the energy sector as 10% cheaper than the overall market. A profile like this puts the odds in your favor, for both superior long term return and less risk.

Alternatively, buy energy stocks at a discount: Invest in exchange traded closed end fund Petroleum and Resources (PEO). Although its two largest stocks, Exxon (XOM) and Chevron (CVX), are identical to XLE’s, it’s outperformed XLE by over 4% annually over the last five years. Especially appealing is that you can buy the portfolio at an attractive 15% discount from its net asset value, while also enjoying a 5% plus annual distribution.

We also like simply buying Chevron. From a tax point of view, outright ownership instead of ownership via a fund gives you complete control of any turnover, and therefore control over the tax ramifications.

Chevron potentially has less risk and greater reward. It’s got the sixth best dividend on the Dow, more than 1% greater than the S&P 500’s average payout. On a multiple of projected 2014 earnings, it’s the Dow’s third cheapest. Debt is low. Its track record is superior; its 6.16% average annual return over the last five years surpasses both energy funds mentioned.

Bottom line, Chevron’s membership in a laggard sector, energy, enhances our confidence that it could be a worthwhile portfolio holding.

Dividend Growth

Everyone loves juicy dividends. Dividend paying stocks outperform low or nil payers. Between 1975 to 2012 the top payers chalked up a higher annual average return (15%) than the non-payers (11%), and with less volatility.

But, the fact is, if your dividend isn’t growing, you’ve essentially got fixed income, like a bond or a preferred stock. And fixed income, as we’ve seen this year, with the broad based bond index Barclay’s Aggregate down 3.4%, even including income, is especially vulnerable to higher interest rates.

The trick to fending off higher rates is to make sure your companies are growing and are sharing that growth with investors in the form of higher dividends. Search for stocks that not only have a healthy dividend but are raising it at a fast pace, and the prospects are good for continued growth.

A solid fund to do this for you is the exchange traded Vanguard Dividend Appreciation ETF (VIG). It tracks companies that have raised their dividends for the last 10 years straight. It yields 2.17% but more importantly it’s raised that payout nearly 8% annually for the last five years. That’ll outpace foreseeable inflation.

However, for greater control and profit potential, create your own mutual fund with direct holdings of dividend stocks. We favor Intel (INTC). It controls 80% of the semiconductor market, staying at the cutting edge of technology by virtual of prodigious R&D spending.

Just as importantly, it boasts the third highest dividend on the Dow, at 4%, and has grown that dividend just shy of 10% annually for the last five years. The tech sector has been a laggard over the last 36 month. If techs play catch up, that may provide an additional tailwind for Intel.

Who’s Kicked Out of the Dow?

The Dow keepers just shook up the index, jettisoning three stocks, Hewlett Packard (HPQ), Bank of America (BAC), and Alcoa (AA), replacing them with Nike (NKE), Goldman Sachs (GS), and Visa (V). While the newly anointed all got a pop in their stock prices, interestingly, history indicates that buying those tossed out may be a better bet.

Just look at what happened at the last Dow change up in 2008. In came Bank of America, out went Altria (MO) and Honeywell (HON). The latter two have outperformed, up 14.8% and 10.3% annualized, versus B of A’s 16% annualized slide. This is consistent with a thorough study of the matter made on S&P 500 changes since 1957, namely that the booted outperform the added.

This makes sense. Those dropped often have decent businesses, but have been laggards, suffered reversals, and thus are ripe to be considered less relevant and subject to index removal. But, that makes them cheap enough to attract investor interest, while management redoubles efforts to right the ship.

We favor Bank of America. First, the whole sector has been a laggard, indeed the weakest sector over the last decade, adding appeal.

Fundamentals are improving: Financials’ downfall was precipitated by a slump in the housing sector; however, real estate has clearly turned around, with many markets experiencing double digit percentage increases. This bolsters the collateral behind many financials’ portfolios, and lessens the need for write offs.

As balance sheets are repaired, financials are receiving regulatory approval to increase payouts. As we know, growing dividends is a big plus.

Bank of America enjoys one of the largest franchises in America, giving it tremendous economies of scale. The stock is cheap, trading at close to book value, and should be a key beneficiary of an improving economy.

Bottom line, Bank of America’s Dow departure improves its investment outlook.



Stocks Discussed: BAC, HPQ, AA, GS, V, MO, HON, XLE, CVX, XOM, PEO,
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