VYM Is Looking Like A Buy Again

Dave Dierking, CFA profile picture
Dave Dierking, CFA
5.95K Followers

Summary

  • The Treasury curve should remain lower for longer making dividend ETFs look attractive again.
  • This fund has 3-4% less risk than the S&P 500 while providing a yield advantage of roughly 100 basis points.
  • While the P/E on this fund is high, a comparison of the S&P 500 earnings yield to the 10-year Treasury rate suggests the market is fairly valued currently.
  • Feel comfortable buying shares of this fund and its 3.1% yield.

Just when the Fed zigged, the treasury yield curve zagged. The widely expected March interest rate hike was supposed to help push fixed income yields higher too but then the opposite happened. Treasuries rallied on the news and the yields ended up dropping. So what happened? My take is that the market got a little spooked by the idea that the Fed may raise rates as many as two more times in 2017 in an environment where real wage growth is stagnant or maybe even declining. We saw a flight to quality on the notion that the Fed may hike too far, too fast and push the economy back towards recession.

If the treasury yields want to stay where they're at, that could be good news for dividend equity ETFs. A couple of years ago, we saw traditional dividend-paying sectors such as utilities and consumer goods rally as investors searched for yields they weren't finding in fixed income. A weaker than expected March jobs report, while not really an indication in and of itself that the economy is slowing, may give the Fed reason to keep a bit of a closer eye on things. If rates remain low and Q1 delivers strong year-over-year earnings growth (6-7% growth is currently forecast), dividend ETFs could be in a position to rally.

One of my top picks in the group right now is the Vanguard High Dividend Yield ETF (NYSEARCA:VYM).

This fund doesn't focus on dividend growth or strength. It focuses on yield. The fund ranks dividend paying stocks by yield (REITs are excluded) and then fills the portfolio until the cumulative market cap of the fund reaches 50% of total available market cap. Since it's market cap-weighted, the fund ends up primarily being invested in large- and mega-cap stocks. The fund's current yield of 3.1% easily tops the 1.9% yield of the S&P 500 and the 2.3% rate on the 10-year Treasury note.

But higher yields can come with risks. REITs and MLPs can enhance a fund's yield but also increase its risk and interest rate sensitivity (the fund reduces some of this risk by eliminating REITs right off the top). Stocks with higher yields could also be the result of weak company performance or a challenging business environment. Given the lack of REITs or MLPs in the portfolio along with the diversification within the fund (over 400 names in all), there's not much evidence to suggest that either of these is a problem with this fund. Perhaps the bigger concern is the fund's relative valuation. The overall P/E ratio sits at 21, well above the 18 multiple of the S&P 500, as traditionally conservative areas such as utilities and consumer goods and services have seen valuations stretched well above historical norms. The yields are attractive to income seekers but these areas could be particularly vulnerable if interest rates start rising.

The current state of the interest rate curve could also be the factor that supports a buy rating on the fund. Just as the FOMC was about to meet in March, the rate on the 10 year Treasury was 2.6% and looking like it was ready to move even higher. Since then, the yield has pulled back to 2.3% while the curve as a whole has flattened. That could be good news on a couple of fronts for High Dividend Yield ETF shareholders.

First, low interest rates tend to be able to support higher valuations. Tom Lydon at ETF Trends did a nice piece recently talking about the long-term relationship between the earnings yield on the S&P 500 and the 10-year Treasury rate. It concluded that at its current rate, the earnings yield on the S&P 500 should be around 4.6%. The current earnings yield is at roughly 4.7% suggesting that the market is relatively fairly valued. That same regression also suggests that if interest rates rise, further moves higher in stock prices need to be fueled by earnings growth as opposed to multiple expansion so keep an eye on how companies do over the next few weeks.

Second, those low Treasury rates make dividend yields that much more attractive. The High Dividend Yield ETF holds around an 80 basis point advantage over the 10-year note. That's probably enough of a difference for yield seekers to stick with equities for now but watch for what the Federal Reserve does. If it follows through on its forecast to raise rates two more times in 2017, that gap will likely close and could cause investors to move back to fixed income.

Conclusion

If you look at the standard deviation of historical daily returns, the High Dividend Yield ETF is roughly 3-4% less risky than the S&P 500. With a correlation factor of around 0.95-0.96, you're looking at an ETF that behaves essentially like an S&P 500 index fund but provides a 100 basis point higher yield. Its 0.08% expense ratio is about as low you'll find among dividend funds.

Interest rate movement will be key for this fund. If the yield curve remains low, investors should continue flocking to dividend equities and this fund in particular.

----------

If you're interested in more ETF analysis and dividend income strategies, please consider following me by clicking on the "Follow" button at the top of this article next to my name. Even if you don't, thanks for taking the time to read!

----------

This article was written by

Dave Dierking, CFA profile picture
5.95K Followers
Editor of ETF Focus on TheStreet.com. A top 5 Seeking Alpha contributor in ETFs. Speaker at events, such as MoneyShow Orlando 2018. To receive notifications of new articles and blog posts as soon as they're published, click on the orange Follow button and become a real-time follower.
Follow

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in VYM over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Recommended For You

Comments (15)

To ensure this doesn’t happen in the future, please enable Javascript and cookies in your browser.
Is this happening to you frequently? Please report it on our feedback forum.
If you have an ad-blocker enabled you may be blocked from proceeding. Please disable your ad-blocker and refresh.