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All year I’ve advocated high-quality fixed income as opposed to stock. My own portfolio was over 80% bonds–the rest was in gold, gold stocks, mining stocks, Asian stocks, and various stores of value.

At the opening Sept. 12, I made a big re-allocation to stocks.

Apropos of our discussion on the beach: the self-feeding problem in the US and elsewhere is massive demand for retirement savings leading to a collapse of yields, pension fund bankruptcy, higher savings, lower growth, in a vicious cycle. That’s why I unloaded my NY munis.

Someone has to benefit from this. The state and local govt pension funds, the insurers, everyone who has to lend money is in trouble. Capital intensive industries with steady cash flows benefit: their borrowing costs should collapse over time. Utilities, basic materials, consumer non-cyclicals, etc. fit the bill.
I screened the universe of stocks for companies with

  1. high LT debt to equity ratios
  2. investment grade ratings (or at least high junk)
  3. low implied vol (below S&P itself)
  4. low earnings volatility
  5. high dividend payouts

and I came up with a portfolio that pays a dividend yield above 6% with less volatility than the S&P 500, all in extremely stable industries (I cheated just a bit — threw in a bit of Israeli telecom and tobacco stocks for yield and diversification). My own optimization method is proprietary, taking account skew and kurtosis and using implied as well as historical vols — but that’s of technical interest.

Seems to me there’s nothing else left to make a bubble out of. It’s the last reliable cash flows out there. If nothing happens they beat investment-grade corporates. (I doubt Obama is going to eliminate favorable tax treatment on dividends — someone is going to tell him it’s not a good idea to blow up the stock market right before elections).

The Adobe (NASDAQ:ADBE) disaster should be a reminder that traditional growth plays are treacherous. Some other seemingly attractive sectors look sketchy. I won’t touch AT&T (NYSE:T) or Verizon (NYSE:VZ): they are in the toy business, not the phone business. Basic cell service costs $40 or $50 a month at the discounters (less than half of what AT&T charges me). AT&T is counting on the iPhone (NASDAQ:AAPL) to keep customers paying more, but how long is that going to last? I dislike consumer stocks except for staples like Bristol-Myers Squibb (NYSE:BMY) or Kimberly-Clark (NYSE:KMB) (people will still buy cough syrup and toilet paper). And the financials are living on an iron lung operated by the Fed. They get cheap money from the government and lever up bonds. If I wanted to invest in that business, I’d lever up bonds myself. No, thank you.

This is a low-expectations portfolio; I expect to beat the after-tax yield on corporate bonds as matters stand, and expect slow bottom-line improvement over time. The Israeli cell stocks Cellcom Israel (NYSE:CEL) and Partner Communications (NASDAQ:PTNR) are mature monopolies with dividend yields north of 10%, subject to some limited regulatory risk.

Here’s the portfolio:

TICKER Allocation
MO 8.5%
BMY 7.6%
RAI 4.3%
EXC 4.2%
DUK 8.6%
PAA 8.7%
CEL 4.3%
ED 8.8%
KMP 8.6%
PTNR 4.3%
GSK 3.2%
DD 4.4%
SO 8.5%
ETP 6.4%
LLY 4.2%
KMB 5.4%

This is not my whole equities portfolio (I own a good deal of gold, oil, mining, and similar names, along with some Asian issues). It’s a substitute for part of my fixed-income portfolio which has done quite well and now appears stupid rich.

Remember that the long-term outperformance of stocks over bonds stems mainly from reinvested dividends. If I’m right that the equity risk premium will be very large for quite a while to come (and maybe forever), corporations who can borrow cheaply will have an incentive to obtain cheap debt and distribute cash to shareholders, or buy back their own stock. This should be true of companies with investment-grade ratings and very predictable cash flows. That seems the sweet spot on the risk-reward spectrum at the moment.

Source: My Personal Stock Picks or Who Benefits From Low Bond Yields?