Back in April, I wrote in our last Quarterly Market Outlook that “sometime soon, we will see a meaningful correction in the stock market. And you shouldn’t do a thing about it—except to continue building your equity positions.” I, for one, stand by my earlier position, although the real focus of the recent volatility was in the bond market.
With the Federal Reserve now signaling that it could start tapering its asset-purchase program by year end if economic conditions warrant, bond yields have risen sharply, knocking equity prices down in the process. Taper-talk scares people, but the Fed won’t wind down quantitative easing until it can really see the whites of the expansion’s eyes—consistently stronger growth and payrolls data. Meanwhile, the Fed has said it won’t even contemplate a rate hike until unemployment hits 6.5%, which it reckons won’t happen until 2015.
Investors must remember that the reason the Fed is starting to talk about taking its foot off the monetary gas pedal is that it sees increasing signs of economic improvement. Normalizing policy is a good thing, albeit a delicate process; I recently broke my ankle, and when the doctor took away my crutches, I had to believe that he saw convincing evidence my bones were sufficiently knitted. Fortunately, they were, and we are seeing similar indications of healing within recent U.S. economic data.
Be that as it may, investors are in a quandary: One cannot and should not fight the Fed, but basing investment decisions purely on the Fed’s actions is inherently dangerous (as many recently found out). While keeping an eye on the central bank, long-term investors should remain focused squarely on fundamentals. With that in mind, let’s take a look at the current state of play across asset classes.
Fixed Income: Rising Yields Don’t Portend Bear Market
This rise in Treasury yields is precisely the “freak out” that we typically see once the Fed begins to seriously contemplate raising interest rates. This time, however, the Fed isn’t going to be raising rates anytime soon. It is also typical to see a reduction in yields after the initial “freak out.” I would not be surprised to see that again over the next few months. Rising yields sting investors with highly rate-sensitive exposures, but Treasuries are not in 1994-like, bear-market territory yet. Something on the order of a 300 basis-point move would be closer to that mark, and I don’t think we’re going to see such a move until the Fed is truly ready to tighten. Incidentally, I’d point out that the backup in Treasury yields showed us that TIPS — Treasury Inflation-protected Securities — are still decidedly for chumps, having lost even more than plain-vanilla Treasuries.
Of course, neither Treasuries nor TIPS provide the income many investors need these days. Some of the more credit-oriented fixed income categories reacted dramatically to the Fed’s taper-talk, but their underlying credit quality has not changed. A strengthening economy makes it more likely issuers will repay their debts on time and in full, not less so. Senior loans actually held up relatively well. Their yield spread to Treasuries had been narrowing steadily since last fall, potentially limiting gains, but June’s volatility made them marginally more attractive. Plus, they continue to offer a degree of protection from rising short-term interest rates, a favored position in the capital structure and relatively competitive yields.
The bond market sell-off extended into international fixed income markets, especially emerging market debt denominated in local currency, which saw its worst single day of performance ever on June 20. The reaction was almost certainly overdone as fund redemptions forced selling, exaggerating losses. Those losses, I believe, open up huge buying opportunities in rate markets, in not in currencies. Foreign currency exposure may not do much for returns amid today’s dollar love-fest but emerging market yields are now more attractive than they had been. Remember, national balance sheets remain generally healthy and monetary policy looks likely to remain supportive. Dabblers in EM (and there are many now) don’t fully appreciate the policy flexibility that most countries have now.
Equities: Favor Dividend Growers and Emerging Market Stocks
Yield-hungry investors have increasingly turned to dividend stocks as a source of income, but I’d favor a specific focus on dividend growers. The share of earnings that companies pay out in the form of dividends remains very low by historical standards, and we’re overdue for a change. I expect more companies to increase their dividends, and for the market to reward those that do. I’d note that dividend growers have historically outperformed high-dividend payers, and they’ve done so with less volatility.1 Dividend growers are also more attractively valued today, bearing a lower median forward P/E ratio than dividend payers; in fact, the latter hasn’t been so richly valued on a relative basis for 30 years.
Emerging market stocks have had a rocky ride this year, with cooling growth expectations, falling commodity demand and curbs on China’s property market weighing on share prices. While emerging market growth may not be as strong as it was a few years ago, the long-term secular bullish case for owning emerging market stocks remains very much intact, and valuations are reasonable. You certainly have to be selective. The emerging market indices are heavily weighted toward commodity-sensitive and capital-intensive industries. These have been responsible for much of the weak performance and are sectors that we continue to avoid. Growth in the developing world is still outpacing that of developed economies—a fact that markets seem to be undervaluing. Emerging markets also continue to benefit from improving governance, strong demographic tailwinds, relatively healthy fiscal balances and increasingly credible, independent central banks.
Source: Ned Davis Research, 5/31/13. Based upon top quartile of S&P 500 Index for each of the dividend growers and dividend yielders. Non-dividend payers excluded. The P/E (price-to-earnings) ratio is a valuation ratio of a company’s current share price compared to its actual per-share earnings over the last 12 months. There is no guarantee that the issuers of stocks held by mutual funds will declare dividends in the future, or that if dividends are declared, they will remain at their current levels or increase over time. Index definitions can be found on the last page. Past performance does not guarantee future results.
1.Ned Davis Research, 5/31/13. Based on equal-weighted geometric average of total return of dividend-paying and non-dividend paying historical S&P 500 Index stocks, rebalanced annually.
Past performance does not guarantee future results.
The 10-Year U.S. Treasury Yield is generally considered to be a barometer for long-term interest rates. Fixed income investing entails credit risks and interest rate risks. When interest rates rise, bond prices generally fall, and a fund’s share prices can fall.
Mutual funds are subject to market risk and volatility. Shares may gain or lose value. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes and political and economic factors. Investments in emerging and developing markets may be especially volatile.
Diversification does not guarantee profit or protect against loss.