Everybody I talk to these days is nervous, although for different reasons. Some are nervous because they feel left behind. They sat on the sidelines and missed the incredible rally we've had since March. Now they're afraid they won't have a chance to participate because the market has been refusing to correct.
Others are nervous because they made a pot of money in the rebound and they're afraid they could lose it all in a replay of last year's meltdown. So they don't know whether to take profits, let their winnings run, or curl up in a fetal position and hope they'll be rescued by divine providence.
Personally, I've been fully invested for some time but two weeks ago I bought some Ultrashort ETFs as insurance and have been killed in the trade. I gradually unwound those and have been raising cash, expecting some sort of correction to occur. I'm still waiting although we may have seen the start of it this week.
Meanwhile, prognosticators have been throwing an alphabet soup of letters at us. Will the recovery be a V, a W, or perhaps an L? I'm leaning towards a V - a fast and unexpectedly strong rebound. But I'm not feeling very confident about it so I plan to continue to take some profits and raise my level of cash in case we get what would appear to be an overdue pullback.
The good news is we do have some profits to take and it would be a shame to see them all leach away in the face of some steep correction that could send investors running for the sidelines again.
The bear case is clear: unemployment is still rising, post-foreclosures still dominate the market, U.S. commercial real estate has not recovered from the slump, corporate profits remain anemic, and corporate revenues are flat to down. The bull case, on the other hand, rests on the steepness of last year's decline and the severity of the reaction from corporate America and companies worldwide to the financial crisis. Employees were savagely dumped, capital spending was placed on hold, and costs were cut everywhere.
Now that we are seeing some glimmers of hope, any revenue recovery should lead to dramatic profit increases on the much lower cost platforms that global industry has put in place. Certainly the biggest worry from where I sit is U.S. unemployment and until we see those job losses flatten out we are not out of the woods. That said, the latest jobless claim numbers, which showed a drop in new workers applying for unemployment insurance for the third straight week, were encouraging.
Fortunately, we can hedge our bets by taking some profits and building cash reserves and/or reinvesting the money in more defensive securities. Several of my recent recommendations have scored nice gains and given the pricier state of the market I would recommend taking half profits in all of these. See my updates for details.
I should stress that there is nothing wrong with any of these securities. It's just that, given the jittery mental state of many investors, I think it would be prudent to play with the house's money for a while and get a little more defensive. It's likely that you be able to rebuild your positions in the securities we're reducing for 10% or 15% less than their current prices if we get the pullback that everyone's been expecting.
Of course, if you already have a lot of cash on hand than there's no compelling reason to sell any of these names. So your decision will be based on what percentage of your account you have in cash and how fearful you are of a significant market correction.
There some relatively low-risk ETFs where you could park some money while we see how all this plays out. For example, take a look at these three funds, all of which are designed to track baskets of U.S. companies that offer respectable dividends.
The three are the iShares Dow Jones Select Dividend Index (NYSE: DVY), the Vanguard Dividend Appreciation ETF (NYSE: VIG), and the Power Shares High Yield Dividend and Equity Achievers (NYSE: PEY). Although all three of these ETFs have the same general goal, it's somewhat surprising to find that their performance has varied greatly. At the time of writing, DVY was down 12% year-to-date, VIG was flat, and PEY was down almost 20%. So, interestingly, these issues have not participated in the market rally so far, which may be good news.
Take a look at the holdings of these three baskets you'll notice some fairly dramatic differences. PEY is made up of the 50 highest yielding companies with at least 10 years of consecutive dividend increases. DVY is composed of companies that have provided relatively high dividend yields on a consistent basis over time while VIG looks a lot like the Dow Jones 30 Industrials to me.
Currently, PEY has a trailing 12-month yield of 5.3%, based on Friday's closing price of $7.45. However, I should note that the monthly payments have dropped off significantly this year and I do not expect the yield to be that high over the next 12 months. This ETF has the most diverse collection of holdings among the three, split between industrials, materials, utilities, telecommunications, and a few healthcare, media, and consumer goods stocks. About 40% of the fund is in the financial services sector. The portfolio emphasis is weighted heavily towards small to mid-cap companies, which explains why this fund fared worse than the other two in the market meltdown. However, it also appears to have more upside potential if the rally continues. The MER is 0.59%.
The iShares ETF (DVY) has 101 positions and is a mix of large, medium, and smaller companies. Some names in the portfolio are immediately recognizable such as Kimberly-Clark, Chevron, and Dow Chemical. Others will only be known to dedicated stock-watchers, Watsco Inc., PPG Industries, and Scana Corp. among them. Distributions are paid quarterly and the last two have been about 39c a share (figures in U.S. currency). The trailing 12-month payout totalled $1.79 which would translate into a yield of 4.4% based on Friday's closing price of $40.78. But based on the payouts for the last two quarters, I suggest it is more realistic to expect distributions in the $1.60 range over the next year for a projected yield of 3.9%. The MER is 0.4%.
The Vanguard ETF (VIG) is the most conservative play. It is designed to track the Dividend Achievers Select Index, which is administered exclusively for Vanguard by Mergent, Inc. There are 186 securities in the portfolio with a focus on large-cap stocks. Top holdings include Wells Fargo, IBM, Coca-Cola, PepsiCo, Wal-Mart, and Johnson & Johnson. As I said, it looks a lot like the Dow 30 Industrials, only bigger. It pays quarterly distributions which have recently been running at about 23c a unit. The trailing 12-month payout is 99.5c for a yield of 2.26% based on Friday's closing price of $43.99. My yield projection for the next year is around 2%. The MER is a very low 0.24%.
Bank of America Preferreds
If you are looking for higher yields and are prepared to take more risk, consider the preferred shares of Bank of America (NYSE:BAC). They were downgraded to junk status last winter amid fears that BoA might not survive, however Moody's announced last month that it is reviewing their B3 rating with a view to a possible upgrade now that the company is profitable again.
I own the Series J issue, which trades on the NYSE under the symbol BAC.PR.J. This is a fixed-rate, non-cumulative preferred that pays a 7.25% dividend based on its issue price of $25. That works out to $1.81 a year so based on Friday's closing price of $21.50 the yield is 8.4%.
These preferreds traded for as little as $4.02 last February at the height of the credit crunch and the U.S. banking crisis. Obviously, they have recovered strongly since then as confidence in the banking system was restored by the massive U.S. government bail-out. The high yield indicates there is still some concern about BoA's future, but at this stage I think the company is recovering well and that the dividend is safe. There is also some capital gains potential here. The preferreds are not callable until Nov. 1, 2012.
I am adding them to our Recommended List for aggressive investors looking for more yield. However, note that they are thinly traded so enter a limit order. The BoA Series X preferreds (NYSE: BAC.PR.X) are an alternative choice with a similar yield. I think these preferreds may be the best overall U.S. bank play right now.
PowerShares Financial Preferred Portfolio
If you prefer more diversification, consider the PowerShares Financial Preferred Portfolio (NYSE: PGF) currently trading at $16. It is based on the Wachovia Hybrid & Preferred Securities Financial Index, which tracks the performance of about 30 U.S. listed preferred shares issued by financial institutions. At least 90% of the assets are normally invested in these securities.
As you are aware, the U.S. financial sector has gone through an extremely rough period and it is not clear that the full extent of the damage is known even yet. As a result, preferreds issued by the banks, insurers, etc. have been beaten down in price and are offering unusually high yields. The situation is not dissimilar to the one we saw in Canada late last year, except it is more extreme in the U.S.
This has resulted in preferred share yields that have never been seen before and may never be seen again. Currently, this ETF is paying monthly distributions of 11c to 12c a unit. Projecting this forward for 12 months, using the 11c figure, we could be looking at a cash yield of 8.25% based on Friday's closing price of $16. But a word of caution: the distributions are not eligible for the Canadian dividend tax credit and will be subject to a 15% withholding tax if paid into a non-registered account in Canada. (The same holds for the BoA preferreds.)
PGF units dropped all the way to $5.16 but have since rallied strongly. However, they are still well below their 2006 issue price of $25 and I believe there is upside potential here in addition to the handsome payout. Top holdings include preferreds from Bank of America, Wells Fargo, Barclays, and JPMorgan Chase. About 69% of the assets are rated BBB or better by Standard & Poor's. The MER is 0.74%. This is my top pick for this month and we are adding it to the IWB Recommended List.
All the above are fairly defensive plays given the uncertain market we are likely to have over the next few weeks. Generally, I think the trend will continue higher after a correction, but it is wise to protect yourself on the downside, play a little defense, and add some more yield your portfolio. So hold your breath for the next few weeks. It's going to be an interesting October.