4 Names That Can Help You Profit From Volatility

Includes: EOD, NLY, XLP, XLU
by: Glenn Rogers

The second week of August was possibly the most volatile one in the stock market's history. If you'd been fortunate enough to be in a coma all that week and woke up late on Friday, you would not have noticed much change. But if you were conscious of what was happening, you experienced some gut-wrenching moves that may have left a lasting impression on retail investors, further shaking their overall confidence in the viability of buying equities.

Personally, I think the S&P downgrade of the U.S. credit rating was something of a sideshow, particularly in view of the diminished credibility of that organization. These are the same people who were completely absent during the financial meltdown and are currently maintaining an AAA rating on France. To me the core of the market gyrations we are seeing is uncertainty over of whether we are facing another recession, potentially a global one, or will be able to maintain some level of growth, even if it is slow and tepid.

In the U.S., we've been locked into a debate on the underlying causes of the weakness in the economy, particularly the lack of job growth. One segment of the political spectrum insists that it is the size of government and the complexity and uncertainty surrounding government regulations that is the root cause of our malaise. It's also suggested that more tax cuts are the way to stimulate growth. I've made a few business decisions with respect to hiring and/or business expansion based on tax policies and regulations. Both the decision to hire and the decision to invest are largely guided by the perceived trajectory of demand.

If you accept that premise (and many don't) your investing decisions will be driven by whether or not frozen government spending policy partially offset by accommodative monetary policy will stifle or enable overall world economic growth. If you do believe there is a chance for growth, then this is an excellent time to acquire some equities. Otherwise, you are better having a substantial amount of cash augmented by a large gold holding, whether that's expressed in the physical product or in the gold miners.

If you are looking for rays of sunshine, you could point to recent retail sales figures which have been positive. We have also seen a slew of quite strong earnings from corporations whose cash levels are exceedingly high and whose balance sheets are very strong. On the other hand, the bond market is telling us that stock prices are too high and very often the bond market gets things right before the equity markets clue in. Personally, I'm in the slow growth camp, but without a great deal of conviction. As a result, I maintaining higher than normal levels of cash in my account, approximately 30%. I also have a higher percentage of gold than usual, approximately 15%, and plan to add more exposure to gold through the miners, which have drastically underperformed the underlying price of the metal so far this year.

Beyond that, I have been rebalancing the portfolio to add more high-yielding stocks. Since the Fed has already told us that interest rates are going nowhere for the next two years, this should mean that equities with high yields have a better chance of surviving any significant pullback in the S&P. These big blue-chips should also participate to the upside (if there is one) at least in line with the broader indexes, if not slightly ahead.

There are numbers of ways to pursue yield. On the fixed-income side, these range from high-quality corporate bonds to junk bonds. On the equities side, the focus should be on large-cap stocks with secure payouts and ETFs that hold a number of solid, high-yielding issues. It is this latter group I would like to recommend since the majority of readers are conservative investors.

For those of you who are not, there are lots of reasons to consider adding some higher-yielding vehicles if you're able to stomach the increased level of volatility that goes along with those riskier assets.

With all of this in mind, I'm going to recommend two conservative ETFs where you can hide out while the market makes up its mind whether we are going to have a full-blown recession accompanied by a major pullback in stocks or the opposite. My guess is it's going to be particularly volatile for the next several weeks before we get some sense of where we are going.

The first ETF is the Utilities Select Sector SPDR Fund (NYSEARCA:XLU), which holds a group of large electrical utilities. These include Southern Corp. (NYSE:SO), Duke Energy Corp. (NYSE:DUK), and the American Electric Power Company (NYSE:AEP). The fund has had a year-to-date performance of 7.9% (to July 31) and yields 4.1%. It is currently trading at $32.39 or 5.6% below its 52-week high of $34.30.

This ETF got whacked during the market pullback but held up better than the indexes in general. Traditionally, this type of utility is financially sound and the dividend payouts are usually conservative and sustainable. XLU is a Buy with a target price of $35.

The second ETF is the Consumer Staples Select Sector SPDR (NYSEARCA:XLP) which holds a group of large blue-chip dividend payers including Procter & Gamble (NYSE:PG) and Coca-Cola (NYSE:KO). This fund has a one-year return of 17.5% and was down just half as much as the broad indexes during the recent meltdown.

It is currently yielding just below 3%. That's more than Treasuries and above the broad market's 2.2% average, thus underscoring this issue's defensive qualities. Consensus estimates are for this group to grow profits by 10% in both 2011 and 2012. Most of the companies in this basket have large global footprints and should perform reasonably well even in a sustained period of slow growth. Year-to-date, the Consumer Staples sector, which represents 11.2% of the S&P 500 Index, performed markedly better than the Index as a whole. We recommend XLP as a Buy with a target price of $36. The shares closed on Friday at $29.55.

The next two securities offer a much higher yield but also may carry more risk. These are not formal recommendations and I won't be tracking them going forward, but readers who are interested in high-yield stocks may want to take a look at one or both.

First up is Annaly Capital Management (NYSE:NLY), which I have owned for some time. It's in a business that does well in a low interest rate environment, investing in government-guaranteed mortgages. I especially like it now that we have been assured by the Fed that the low interest policy will be extended for at least two years.

The stock is structured as a REIT and yields 14.6%, which de facto indicates that it is carrying some risk. However, I was delighted to see that Bill Gross, the famed bond trader who founded PIMCO, perhaps the most respected fixed-income company in North America, recommended Annaly twice this year. The first time was in the Barron's Roundtable January issue. Then he mentioned it a few weeks ago at the mid-year update. In picking Annaly, he stressed that this is strictly a dividend-paying vehicle with little or no upside on the price side.

"The stock can't go up much because the minute the price gets above book value the company issues stock, as it did in late December," he said. "But it produces a 14.5% yield. This is a finance company like AmEx or GMAC or CIT, although CIT is lower-quality than Annaly."

Annaly invests mainly in mortgages that are guaranteed by government agencies. However, these are not subprime mortgages. They are mostly floating-rate adjustable mortgages backed by Fannie Mae and Freddie Mac and, ultimately, U.S. taxpayers. So there is not a lot of default risk here. However, as Gross pointed out, the portfolio is subject to a lag in interest rates.

The rates on these mortgages adjust every six to 12 to 18 months. If interest rates went up by two percentage points tomorrow, Annaly's cost of funding would go up by that amount but the rates on the mortgages it holds would go up 12 to 18 to 24 months later and the company would have to cut its dividend. So there are risks here, but not in terms of the creditworthiness of the collateral. It is more in terms of the cost of financing, which gets back to my original thesis: the benefits of borrowing at negative real interest rates.

At the current price of $17.79, Annaly is trading about $2 above its book value of $16 a share. Says Gross: "You are giving the company the privilege of investing money for you, levering it 5-to-1, and offering you a 14% dividend yield. In the absence of another crisis, you'll do well."

However, before buying any shares of Annaly, Canadian investors should discuss the tax implications with a broker or accountant. Under the Canada-U.S. tax treaty, U.S. REIT distributions to Canadians are subject to a withholding tax of 15%, which can be offset by claiming a foreign tax credit if the shares are held in a non-registered account. Investments in retirement plans such as RRSPs and RRIFs are theoretically exempt from the tax but this does not extend to TFSAs and RESPs. And because REIT distributions may include dividends and capital gains, they might be hit with the 15% withholding even inside a registered plan. In that case, no foreign tax credit can be claimed.

Also note that the payments do not qualify for the dividend tax credit and any capital gains distributions are treated as foreign income and taxed at your marginal rate -- the 50% inclusion rate does not apply. With all these complexities, you can see why I advise getting definitive tax advice before making a purchase, despite the attractive yield.

Finally, I came across a Wells Fargo closed-end fund in my research that looks interesting. It's known as the Advanced Global Dividend Opportunity Fund (NYSE:EOD) and at $8.55 yields nearly 13% after the recent meltdown. It's trading at a 20% discount to its highs and prior to this recent volatility had been steady as a rock for a number of months. The fund owns a vast array of preferred share issues from around the world and I think this is a nice way to have a level of safety tied to high-yielding global stocks without having to work too hard. The yield is an impressive 13.1%.

Disclosure: I am long NLY, XLP, XLU.

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