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In Part 1, I discussed the existence of the Yield Vigilantes -- who they are and where they came from. The idea is that there is a massive group of investors out there who are starving for yield and are willing to buy income securities on dips. Because of that hunger and their need for yield, there's something of a floor in place

In Part 2, I codified a strategy for enhancing your risk-adjusted yield. The basic premise is to decrease your weighting to bonds when yields are at cyclical lows and boost your exposure to quality dividend stocks.

Today we're going to more clearly define our parameters.

One Signal To Rule Them

Interest rates are your only signal in this strategy. That's one of the benefits. Easy.

Interest rates incorporate a ton of information. In fact, they're probably the most important single data point in the world. And within the world of rates, I'd say that two are more important than all the rest: LIBOR and the 10yr US Treasury yield. Unfortunately, LIBOR is basically zero and it hasn't told us anything interesting for quite some time. Nor will it any time soon.

The 10yr yield is a different animal. It's remarkably range-bound.

(click to enlarge)

In a basic sense, when rates get close to the green line, you want to be overweight bonds and underweight dividend equities. When rates approach the red line, you want to be underweight bonds and overweight dividend equities.

Skimming back through time, this has been a rather prescient indicator. Consider the last few local extremes:

  • January 2010 -- buy bonds
  • December 2008 -- buy stocks
  • April 2006 -- buy bonds
  • July 2002 -- buy stocks
  • October 1999 -- buy bonds
  • July 1998 -- buy stocks
  • October 1994 -- buy bonds
  • August 1993 -- buy stocks
  • September 1987 -- buy bonds

The first thing you'll notice is that the yield signal is early. It doesn't get you in at the exact bottom or out at the top. But we all know that perfect indicator doesn't exist. Nobody can pick the tops and bottoms with perfect accuracy and consistency. Though the 10yr Treasury yield does an admirable job of it.

Heck, I should probably stop making my own predictions and just let the bond market do it for me.

How to Identify a Local Extreme

It's easy to point out a cyclical top or bottom in hindsight. Doing it in practice is a little more difficult. The good news is that there is a box of pre-built technical indicators at our disposal. Pretty much any oscillator will do, provided we give it the right inputs and tune it to the proper parameters. I'm a fan of the Relative Strength Index (RSI), and we forget that we can use it for assets aside from stocks and use it for periods longer than the common 14.

In this example, I'm using a 52-week RSI on the 10yr Yield:

(click to enlarge)

A reading over 65 in this data set would qualify as an extreme high. Here's when it had you overweighting bonds:

  • December 2010 (!)
  • June 2009
  • June 2007 (!!!)
  • May 2006
  • August 2003
  • May 2004
  • December 1999 (!!!)

For easy interpretation, I've overlaid those onto a chart of the S&P:

(click to enlarge)

Some of those signals are downright eerie. Some aren't very good, like June 2009. Others, like the signal in May of 2006 are interesting. They saved you some short-run heartburn.

A word of caution: like any of these overlays and oscillators, it's a bad idea to use them on their own in a vacuum. Technical indicators always need to be used in conjunction with others. No serious trader runs a naive system where they simply buy asset X when the RSI is above Y.

Feel free to find your own technical and quantitative signals to enhance the quality of this. I tried a few others and got mixed results.

But honestly, the most effective and easiest indicator to incorporate were simple trendlines.

(click to enlarge)

Start rotating into bonds at the green line and into dividend stocks at the red line. Maybe rotate between a 70/30 and 30/70 weighting, depending on your portfolio objectives and risk appetite.

At the very least, you can just call up your financial advisor when the RSI is high and the yield is at the upper end of the band. Say, "Hey, Bob, I want to move more of my portfolio into higher quality fixed income and Treasuries." He'll call you nuts, of course, because this is technically a contrarian strategy and the stock market will have been going up for a while.

And when you tell him you want to buy more dividend stocks, when the 10year yield is down near the red band, he'll think you're equally crazy. He'll say, "Uh, haven't you been watching the news? THE FINANCIAL WORLD IS IMPLODING!!"

Or maybe he'll stroke his chin whiskers and say, "innnteresting." Maybe he'll think you're clever like a fox. If that's the case, he's probably a financial advisor worth hanging on to.

Jeff's Nearly-Thinkless Yield Strategy aka "How to Be a Yield Vigilante"

  1. One signal. The goal is to be overweight bonds when the 10year Treasury yield is at a local peak and overweight high quality dividend stocks when the 10year yield is at a local low.
  2. Plot Trendlines and watch the RSI. The trendlines will provide historical context and a tuned RSI will help you spot local moves in real time.
  3. When you're near the upper band, buy bond ETFs like (NYSEARCA:TLH), (NYSEARCA:IEF), or (NYSEARCA:AGG).
  4. When you're near the lower band, buy ETFs like the Dividend SPDR (NYSEARCA:DVY), or dividend champs like Johnson & Johnson (NYSE:JNJ), Consolidated Edison (NYSE:ED), Intel (NASDAQ:INTC), Procter & Gamble (NYSE:PG), Verizon (NYSE:VZ), AT&T (NYSE:T), or something like Annaly Capital Management (NYSE:NLY) if you like it spicy. Seeking Alpha has dynamite content on dividend stocks every day.

The last bit of good news is that this strategy doesn't involve a lot of transactions. Keeping your costs low is a big part of long-term outperformance, as is maximizing your tax efficiency. This simple strategy gives you freedom to keep as much of your gains as possible in the long-term category.

Strategies that don't require frequent maintenance are also good because you can avoid a lot of the headline news noise and prevent yourself from overthinking the trade. It's another way of forcing emotion out of the process. I'm of the belief that nothing is more consistently damaging to investors than emotion. The less opportunity for you to screw it up, the better. Plus, more time for golf!

Source: How To Be A Yield Vigilante, Part 3