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It's the number one question in all of finance: Where can I pick up some yield?

I hear this all the time from investors that I talk to in person. It's a common denominator in most of the strategy discussions I hear on Bloomberg and CNBC. And judging by page traffic here at Seeking Alpha, Dividends & Income are what retail investors care about most right now.

This article is a more focused, tactically-oriented version of a more detailed newsletter I wrote yesterday. This article is designed to serve as a companion piece, so I won't repeat much of what I've already written.

Rise of the Yield Vigilantes

Everybody remembers the famous term, "bond vigilante." The idea was that if a government was up to no good and doing fiscally irresponsible and inflationary things, bond investors would simply rally together and sell the country's debt, creating natural, upward pressure on interest rates. That, in turn, would make it more costly for the government in question to borrow. Believe it or not, the yo-yos that run this country (and others) have a pretty solid grasp on basic game theory. In normal times in normal markets, the concept of the bond vigilantes kept governments relatively honest. Basically, it kept countries with printing presses from using them.

Those guys are all dead now. In their place a new breed has arisen, the "Yield Vigilante."

Who is a Yield Vigilante? In its simplest sense, it's someone who's starving for yield.

  • A large pension fund with a specific yield mandate for its benefit programs.
  • An institution with a lot cash to manage and a need to keep risk manageable .
  • Another government who needs to buy securities to generate yield for its own reasons.
  • The masses of retirees living off an investment portfolio and a fixed income.

These are the guys that are going to keep rates from rising too high. I'm not buying into a scenario where yields spiral out of control, higher and higher. When interest rates approach a local peak, vigilantes who remember that 1.5% yield on 10yr Treasuries will buy plenty of bonds and like it.

In fact, I think the future of our bond market will look more like Japan's (though for different reasons).

(click to enlarge)

Depressing Yields

I started writing about this low yield environment back in late 2009. My idea was for investors to make peace with fundamentally lower yields and rates of return rather than go too far out the risk curve. What matters to me is risk-adjusted return, not absolute or relative return.

In one sense, I was totally wrong with that approach. Risky assets are quite a bit higher today than they were back then. But wow, what a ride! We're in the midst of our third major scare in three years -- Europe, Debt Limit, Greek Exit -- and it's sensible to expect that these periodic bouts of volatility will continue.

Since 1/1/10, the S&P 500 is up around 15%. Was the ride worth it?

Depending on how I cherry picked my dates and how I wanted to tell this story, I could make that number as big as 109%, which is the March crisis lows through this year's high. Or I could make it as small as 8%, which would represent the pre-EU mess high (April 2010) through today. Or I could use a date like the beginning of 2011, when most of the QEnthusiasm and mean reversion forces had run out of juice, and claim that the market is pretty much flat since then.

My point is that with this kind of data set, there are plenty of narratives to spin:

(click to enlarge)

The common denominator to any of those narratives is that stocks are going to involve some volatility. I know that's pretty obvious to anyone who has invested in them in the last century or two, but it's worth mentioning to income investors who have previously relied on the bond market to satisfy their needs and had the luxury of being able to ignore the moody month-to-month swings of the market.

A proper income strategy these days has to incorporate both bonds and stocks. And to do that you need a way to smooth out some of the volatility endemic in the stock market.

The Strategy

If you like risk and movement and ACTION, stop reading. Seriously. How did you even make it this far into the article anyway?! What were you doing in the Dividends & Income section?

But if you're bummed about the low yield environment and are looking for a way to turn lemons into lemonade -- or, if you're like me, a way to turn limes into a mojito -- then I think this market agnostic strategy could work for you.

(click to enlarge)

At the top level, this is a basic rotational, asset allocation approach. I like to buy stuff that's cheap and sell stuff that's expensive. I don't really care what it is that I'm buying or selling. That's just me. You may feel differently.

The idea is to overweight bonds when interest rates are at a local peak. That's when they're cheap. Then you ride 'em for a little while and when rates reach a local valley, you start swapping them for more dividend stocks. When rates are at a local valley, it's a good bet that stocks are in the middle of a pretty hefty drawdown. Cheap, in other words. And with higher dividend yields!

The reason why I dig this strategy is that rates are the only signal you have to worry about. Forget about Europe, the economy, and the election. You're a Yield Vigilante and all you care about is risk-adjusted yield. It's a tough world out on the veldt. There are lots of other hunters looking to shoot a gazelle, a wildebeest, anything with some meaty yield on its bones. So you keep your gun loaded and eyes open. When the environment is right, pull the trigger and take it down.

Right now we are at a local low in interest rates. So you should be (perhaps heavily) overweighting dividend stocks. You should be doing that right now.

Don't believe me that we're at a local low in rates? Here's a 5yr chart of the 10year Treasury.

(click to enlarge)

Honestly, with this strategy, you probably got your signal last September. That's when you would have started to load up on and rebalance towards solid stocks with healthy dividends. And that was a good signal, too. Even with the recent pullback, you'd have somewhere around 10% of capital appreciation on that trade plus another 3% or so of dividend income depending on what kind of stocks you bought. (To be fair, you'd have some capital appreciation on your bonds, too, had you just held them through now.)

Put another way, now is a time to be buying stocks. I wrote about another good medium-term signal a couple of weeks ago here at Seeking Alpha. Sentiment is kinda bearish right now, and historically, that's meant that you should be kinda bullish instead. But if you're a Yield Vigilante, all you care about yield, which at this point in the strategy comes more from your dividend stocks.

Every day there are a dozen new articles here about dividend stocks, so I won't waste too much time sifting through all the names and reasons. My preference is for strong balance sheets, defensible business models, and a history of growing that dividend.

I did a simple screen at my brokerage and came up with 10 suggestions to get you started:

CompanyCurrent Yield5-yr
Dividend Growth
Anheuser Busch InBev (NYSE:BUD)2.3%10.3%
3M (NYSE:MMM)2.8%

7.6%

McDonald's (NYSE:MCD)3.2%20.4%
Teva Pharmaceutical (NYSE:TEVA)2.5%12.7%
Lowe's (NYSE:LOW)2.3%24.1%
General Mills (NYSE:GIS)3.2%10.8%
AT&T (NYSE:T)5.2%5.1%
Intel (NASDAQ:INTC)3.2%14.4%
Microsoft (NASDAQ:MSFT)2.7%12.8%
Johnson & Johnson (NYSE:JNJ)3.9%9.1%

Plenty of companies fit that basic profile. Those are a few of the big names. Go ahead and choose others that you like. Personally, I categorically ignore financials and anything with a yield about 6%. Stuff like that carries risk that I don't want to deal with. But you might, and the good news is that this strategy is super-flexible.

The point is to understand that, on a risk-adjusted basis, you can do a little better with your portfolio if you mix in some very basic timing and a bond component.

The last thing you'll need to do is figure out your minimum and maximum levels of bonds and dividend stocks. That's a very personal thing. But I do believe this all works best as an asset allocation strategy. Technically, this is a yield-enhancement strategy.

To recap:

  1. When interest rates are at the low end of the range (like now), underweight bonds and overweight high quality dividend stocks.
  2. Enjoy your dividends and hopefully some capital appreciation.
  3. When interest rates get near the high end of the range, unload those lovely dividend stocks and overweight low risk bonds or Treasuries.

Wash, rinse, repeat. A lot of long-term strategies stopped working in 2008. But I think this one keeps right on rocking through the next decade. It's a simple way to improve your risk-adjusted yield without dabbling in anything too complex.

Nothing in the world is more cyclical than interest rates, too, so they're as good a signal to follow as any:

(click to enlarge)My favorite chart in the world

A More Specific Approach

Stay tuned for Part II of this strategy next week. I plan to quantify this approach even further, define more exact parameters, and run some simulations. I promise I'll update you as soon as I've got all the details finalized.

Source: Yield Vigilantes And How To Join Them

Additional disclosure: You should read the legal notice at cognitiveconcord.com/legal-notice/