The S&P has rallied nearly 50% from its lows and is up over 10% year to date. For those that sat out the rally, afraid to get in, the market is starting to look (at the very least) fairly valued. It’s hard to say where things will go from here. But, a closer look at the leaders of the recent rally sheds some light on some stocks which just might have been overlooked. Not having benefited from the powerful rally we’ve just experienced, it would stand to reason they will have less to correct should the market turn and offer more of an opportunity for appreciation as investors continue to look for uninflated assets.
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The above chart graphs the Dow Jones Industrial Average against a proxy for tech stocks (NASDAQ/QQQQ), small cap growth stocks (IJT), and emerging markets stocks (EEM). What we see is that, while Dow Jones has rebounded off of lows, it remains barely positive on the year to date and has severely lagged the three other indexes identified in the chart. Despite being in a recession and all the talk of a “flight to quality,” the Dow Jones seems to have fallen just as hard as any other stock categories yet has been left behind in the subsequent rebound.
It would seem that investors have flocked back into higher risk assets – emerging markets, tech and small caps – before taking a chance on boring U.S. large caps. Now, with the market seeming to be sputtering a bit after such a prolonged bounce, it would seem to be prime time to look at U.S. large caps. These companies due to their size should be leveraged nicely to any sustained rebound in the “real” economy and will likely benefit from a “return to quality” should markets correct.
For those who have sat out the rally still shell shocked by the events of the last 18 months, these stocks continue to pay hefty dividends which, given low interest rates elsewhere, should make them attractive just for their relative liquidity and safety. While I’m not advocating using Dow Jones stocks as a savings account, they can function well for the risk averse, income oriented investor to augment loss of income due to declining interest rates.
Which of the Dow components look most promising? Well if you subscribe to the Dow Underdogs theory, laggards year to date include Exxon (XOM), General Electric (GE), Procter & Gamble (PG), AT&T (T) and McDonald's (MCD).
Personally, I would also like to overlay stocks with dividend/free cash flow between 25% and 50% (the comfortable payout zone). I generally believe that companies paying above 25% of their free cash flow show a true commitment to their dividends while maintaining dividends below 50% of cash flow provides a bit of a safety net in the event of any unforeseen issues in operations.
Doing a quick screen to find Dow components offering dividend yields greater than 3.0%, with a payout ratio within my comfort zone, I found Johnson and Johnson (JNJ), Procter and Gamble (PG), Pfizer (PFE), Merck (MRK), and Caterpillar (CAT). The only crossover between the Dow underdog list and my quality dividend list? Procter and Gamble! I think this one deserves a deeper dive.
Full Disclosure: Author is long shares of JNJ and GE. No positions in any other stock mentioned.
