Opinion: 4 reasons why income investors should favor stocks with nice dividend yields over bonds as the Fed tightens

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With stocks swinging more wildly and the Federal Reserve poised to take away the punch bowl by raising interest rates, now’s the time to sell stock and head for the safety of bonds, right?

Don’t do it.

This is a popular trade right now, but history gives us at least four reasons why bonds will likely sink in value from here.

As for stocks, the rate hikes forecast in the Fed meeting Wednesday won’t be an issue for the S&P 500
SPX,
-1.03%,
the Dow Jones Industrial Average
DJIA,
-1.48%
or Nasdaq Composite
COMP,
-0.07%.
History shows that when growth is as robust as it is now, bull markets can sustain several Fed rate hikes and still march higher.

The upshot: It makes more sense to achieve your income-investing goals via stocks with decent dividend yield that also offer the potential of capital appreciation. Depending on your portfolio mix, age and risk tolerance profile, of course. I suggest three below.

First, the reasons to avoid bonds now. As you read through these, remember this basic point about bonds: Bond prices and bond yields move in opposite directions. When bond prices fall, bond yields rise.

1. Sustained, elevated inflation tells us bond prices will sink

Going back 50 years, there’s a pretty tight relationship between inflation and bond yields (and therefore also bond prices). Consider two key takeaways from the chart below, provided by Yardeni Research.

First, bond yields (the red line) and inflation (blue line) move roughly in line with each other. Second, bond yields are typically higher than inflation, or at least even with it. This makes sense, because who would put money into an investment that loses them money right from the start (negative real yields)?

Currently, this historical relationship is completely out of whack. Inflation is much higher than bond yields. This suggests bond yields will rise, and bond prices will fall. Of course, inflation might come down instead, to restore the balance. But that’s not likely to get the whole job done. Inflation will fall but remain elevated next year, probably in the 3% to 5% range, predicts Ed Yardeni.

2. Manufacturing strength forecasts lower bond prices

Here’s another classic yield forecaster: the ISM manufacturing purchasing managers index (PMI). It measures the activity level of purchasing managers. As the chart below shows, the PMI and bond yields typically track each other. This makes sense because as the PMI rises, that suggests higher growth and a bias toward inflation, which usually inspires investors to get out of bonds, driving up bond yields. Again, we see that this relationship has broken down. It is more likely to resolve in higher bond yields and lower bond prices, since economic growth will remain robust next year, given all the stimulus and pent-up demand (strong consumer and corporate balance sheets).

3. The copper-gold ratio points to lower bond prices

Economists like to quip that “Dr. Copper” has a Ph.D. in economics because of the metal’s great forecasting abilities. Indeed, a trusty forecaster of bond yields is the ratio of copper prices to gold. Think it through like this. Strong copper prices can be a forward indicator of growth, since it is an industrial metal. High gold prices can be a measure of caution among investors whereas lower gold prices suggest investor bullishness on the economy. So, when copper prices are strong relative to gold, it can suggest strong growth ahead and thus inflation, which hurts bond prices (driving up yields).

You can see in the chart below that the copper-gold ratio is telling us that bond yields will go up from here, and bond prices will fall.

What might make bond yields go up and bond prices fall? The Fed itself. Many people speculate 10-year bond yields
TMUBMUSD10Y,
1.407%
have remained so low against all odds because of the heavy Fed buying of these bonds as part of its quantitative easing. Fed buying has artificially pushed up bond prices and lowered yields, by this theory. So, as the Fed tapers (reduces buying) that will remove some price support, causing bond prices to fall, and yields to rise. The Fed just told us it is speeding up its tapering, so this impact may happen sooner rather than later.

4. Bonds don’t reduce volatility when yields are this low

To identify whether bonds in your bond-stock mix reduce volatility without hurting returns too much, it helps to break history into two periods: Times when yields are below 3%, and times when yields are above 3%. It turns out, when yields are above 3%, owning bonds in your portfolio dings overall returns only a little, but reduces volatility quite a bit. In contrast, owning bonds in your portfolio mix when yields are below 3%–like they are now—dings your returns quite a bit, and doesn’t help reduce volatility as much, according to analysis by James Paulsen, an economist and market strategist at Leuthold Group.

This makes sense because when yields are low, it suggests the economy has room to grow—helping stocks—before interest rates rise enough to hurt growth. And, simply that bonds are less attractive because they are more expensive.

Corporate bonds won’t help you

Another word of warning for income investors: Don’t look to corporate bonds for refuge. They’re priced to perfection. The difference between yields on riskier corporate bonds and government bonds (the spread) is tight and very low by historical standards, points out Capital Economics economist Nicholas Farr. Historically, when spreads have been this tight, corporate bonds haven’t performed well relative to government bonds. “We see little upside for developed market corporate bonds,” says Farr.

What about stocks?

Won’t the coming rate hikes confirmed by the Fed this week hurt economic growth and the stock market? Probably not, simply because growth is so robust. Historically, when economic growth is above 3%–which we’ll probably see through all of next year—the Fed was able to hike multiple times before the bull market in stocks faded. In contrast, when the economy is hovering near “stall speed” with growth running at around 2.5%, it doesn’t take much Fed tightening to kill off the economy and therefore the bull market, notes Paulsen.

History shows that when growth is as robust as it is now, bull markets can sustain several Fed rate hikes and still march higher.

If you are an income investor, you should take advantage of these insights and favor stocks that pay decent yields and offer capital appreciation potential, as well. “You can make more money being in dividend paying stocks than you can in the 10-year treasury bond,” says Neil Hennessy of Hennessy Advisors.

His shop singles out the life insurance company Manulife Financial
MFC,
-1.47%,
which offers a 4.7% yield, and WEC Energy
WEC,
-2.10%,
a utility that pays a 3% yield. In my stock letter (link in bio below) I’ve singled out the real estate investment trust American Assets Trust
AAT,
+0.76%.
It pays a 3.7% yield and offers exposure to economic growth because it is in retail, office, hotel and multifamily residential properties in high growth markets in California, Washington and Texas. Insiders with good track records have been buying huge amounts, a bullish signal.

Michael Brush is a columnist for MarketWatch. At the time of publication, he owned AAT. Brush has suggested AAT in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks

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