When The Dust Settles: Dividend Stocks Still The Place To Be

Includes: DIV, DVY, FDL, FVD, MDIV
by: Rising Dividend Investing

At the beginning of the year, investors were driving up the prices of defensive stocks (healthcare, utilities, and consumer staples) over more growth-oriented stocks (financials, cyclical, and industrials). In a traditional bull market, growth stocks lead the charge. At the time, investors were willing to pay almost as much per dollar of earnings (expressed by the P/E ratio) for safety and income as they were for growth. In fact, utilities were trading at a higher P/E than industrials and financials. The market was being driven by fear, and growth stocks were not being rewarded.

We knew that would change. As we stated on May 20, 2013: "The market will begin to be driven more by greed than fear. As that happens, we expect investors to shift their focus from defensive sectors to more growth-oriented, cyclical stocks."

To position ourselves in a way that would take advantage of the future shift to growth, we tilted approximately 12% of our portfolio away from some of the defensive sectors into more cyclical, growth-oriented sectors. The stocks we bought have outperformed the defensive stocks we sold by around 8% on average.

Interest Rates to Stay Low

Led by Senior Fixed Income Manager Joe Zabratanski, our macroeconomic committee forecasts that the recent scare and uptick in 10-year Treasury yields will eventually die down. This will leave the 10-year U.S. Treasury yield residing in a range between 2.5% and 3.0% for the next 12 months. Here is why:

1. Slow Economic Growth

Rising interest rates are usually an indicator that the economy is heating up. While the outlook for the U.S. and global economies is improving, economic growth is still muddling along. U.S. nominal GDP continues to be a very meager ~3%. This low growth environment is not conducive to rising interest rates.

2. No Inflationary Pressure

There is a long-term positive statistical relationship between inflation and the 10-year Treasury yield. Inflation has and continues to be very low. In July, the Bureau of Labor Statistics reported the Consumer Price Index was 1.8%. There is simply not enough economic demand to push employee wages or prices higher.

3. The Fed Won't Let Rates Rise

The Fed wants interest rates to stay low in support of home purchases, business investment and continued economic growth. If economic indicators do not improve as expected, the Fed could continue QE for longer than forecasted. The unemployment rate is nowhere near the Fed's 6.5% target, and inflation concerns are more about deflation than reaching the Fed target of 2.5%. Bernanke also stated that the Fed intends to hold on to the bonds on its balance sheet for some time, which would put additional downward pressure on interest rates -- even after QE is ended.

The combination of these three factors is compelling evidence that interest rates will remain low for the foreseeable future. Bernanke stated that the Fed will keep rates short-term interest rates low until at least 2015. We believe it.

When the Dust Settles

There is a lot of confusion right now in both the stock market and the fixed-income markets. Fixed-income investors have been selling bonds like they expect rates to go up to 4%. We don't see that happening. Detroit's default has made municipal bond investors fearful that there are more cities like Detroit out there. We believe those fears are largely unfounded. Worries about Europe collapsing are receding, but investors are now concerned that China's economic data has not been as good as expected. Earnings in the U.S. were not great, but were better than expected.

When the dust settles, we expect that interest rates will continue to stay very low. The chances of a recession in the United States are still very unlikely. Unacceptably low rates will force investors to seek alternative ways to produce income and return. This continues to make stocks attractive, especially those who are committed to paying and consistently growing dividends year after year.