Market Update - Volatility Ahead
The stock markets have been pulling back sharply following the escalation of tensions between the U.S. and China, and following the "less dovish than expected" statement from the Fed Chairman Powell. So what comes ahead?
It looks like we will be breaking major resistance levels today, and we are likely to see a lot of market volatility. Even more, we are likely to see a mini-market correction, which would take the S&P 500 index (SPY) back to the 2850 level and possibly to the 2800 level, or a pullback of another 2% for the S&P 500 index.
Why Investors Should Not Worry
Market corrections and mini corrections are quite normal during any bull market. I'm not particularly concerned about any market volatility because all economic and market data point to a sustainable bull market:
- First, the U.S. economy is doing much better than most analysts have expected. It's also likely to keep doing well going forward. The trade war does not impact the U.S. as much as it impacts China because the U.S. economy is mainly driven by consumers rather than by imports and exports. U.S. consumers are currently doing pretty well due to low unemployment and rising wages. I do not expect anything to change anytime soon on this front. On the international front, the European and Asian economies have been on the decline. However, we have indications that we are likely to reach a bottom soon, and that deceleration is likely to stop, mainly due to recent interest rate easing by global central bankers to boost growth. The latest IMF report suggests that global growth should bottom by the middle of the year, and there should rising growth by the second half of 2019. So future economic data is likely to look better in the future than it's looking today.
- Equity prices are not expensive by any measures. First, due to earnings growth, today stock prices are even cheaper than they were a year ago. Second, one of the most important measure to value stocks is based on dividend yields compared to Treasury yields. The U.S. 10-year Treasuries have sharply pulled back and today yield 1.85%. On the other hand, the S&P 500 index currently yields 1.91%. When the S&P 500 index yields more than the 10-year Treasuries, this tend to be very bullish for stocks.
- About interest rates: Although the Fed was more dovish than the market expected, they will have no choice but to further cut interest rates in 2019. The Fed's main job is to do everything possible to avoid a recession, and I'm confident that they are aware that recession risks will be on the increase if nothing is done ahead of time. I expect at least one rate cut of 0.25% in 2019 and most likely two rate cuts. This will help the markets go higher.
- We are at the last stages of the economic cycle and the related bull market. This stage tends to end when stock valuations become irrationally high and when investors become Euphoric. We clearly do not have either of these factors that would signal the end of the current bull market.
- A trade deal with China is likely to be made sooner or later. Neither country can afford to keep trade tensions the way they are, and certainly not China as they have the most to lose. I expect a settlement over the next 12 months which would be bullish for equities.
What Is The Best Course of Action?
For those income investors who are fully invested, the best course of action is to sit tight and keep collecting the hefty dividends. Note that I am myself fully invested and have no intention to trade. For those investors who still have cash on the sidelines, it will be a great opportunity to start deploying it over the next two weeks. I do not expect this pullback to last more than two to three weeks. The bottom line is that this is likely to be a temporary pullback, and this bull market is set to resume in full force.
How Are We Protecting Ourselves From Market Volatility?
We currently have three strong hedges for our portfolio:
- Allocation to Defensive High-Yield Sectors: We have 40% of our portfolio allocated to fixed income, including bonds, baby bonds, preferred stocks, and fixed income CEFs. These defensive investments tend to either go up in price when the equity markets pull back, or remain flat. This is our best hedge against market volatility. Furthermore, defensive property REITs such as Iron Mountain (IRM) and EPR Properties (EPR) among others we are recommending tend to be pretty resilient during pullbacks. The same can be said about the utilities sector such as Reaves Utility Income Fund (UTG) which is a defensive sector too. For that investors who do not have a full allocation in fixed income, Property REITs and utilities, I strongly recommend that you do so. Having a balanced high-yield portfolio will protect you against market shocks and tends to strengthen your holdings and income over the long term.
- Allocation to recession resilient high-yield stocks: We have been avoiding high growth stocks such as technology (QQQ) because they tend to trade at very expensive valuations and are the most vulnerable to market pullbacks and to a weakening economy. We have been favoring lower growth high-yield stocks that are recession resilient. By nature, lower growth stocks depend less on a thriving economy to cover their dividends, so they tend to be much more defensive. One great example of hedging with recession-resilient stocks is our recommendation to buy Annaly Capital (NLY), an mREIT that's set to double in price in case we hit a recession. NLY yields close to 11% and is among our best defensive positions. We are currently recommending many similar defensive investments to our members, many of which yield between 9% and 11%. These companies tend to make money in both good and bad times because they do not rely much on economic growth to generate income.
- Allocation to the Midstream Sector: Midstream companies are inherently defensive ones. These tend to own oil and gas pipelines that are quasi monopolies because this is a highly regulated industry and it's very difficult and expensive to build competing pipelines due to very tight regulations. These companies generate income based on volumes of oil and gas that's transported, rather than the price of the commodity itself and they have very little dependency on the state of the economy. They also generate great income in both good and bad times. Note that this sector has been strongly out of favor and has been pulling back together with upstream companies (or companies that are in the exploration of oil and gas). The sentiment is likely to be shifting soon as the oil and gas sector is currently seeing some of the strongest earnings growth among all sectors of the S&P 500 index. Once the sentiment starts to shift, midstream companies are set to see large great gains in addition to the hefty yields they currently offer. Note that the midstream sector is currently trading at its lowest valuations in years, and offers a great buying opportunity. Some of our favorites include Energy Transfer (ET) with a yield of 8.7%. The sector's outlook is stronger than ever, and patient investors are set to be well rewarded.
Outlook on Inflation
Inflation going forward is likely to be very muted. We touched on this subject several times. The main driver for inflation is demographics. A strong population growth is key to inflation which we clearly do not have. Currently, the population growth rate in the United States is at its lowest in decades. At the same time, the population is aging and many are entering retirement age. This further puts downward pressure on inflation. I would not be surprised to see inflation nearing zero in a couple of years. Income investors can expect that inflation rates going forward would be much more muted than they were in the past decades. Just look at Europe and Japan. Because of low population growth and aging demographics, inflation is at nil or even in negative terms. It's only a matter of time for the U.S. and Canada to reach the same situation.
So at least a lower inflation rate will play in favor of retirees and those planning or retirement.
The Bottom Line
The current bull market is still alive and kicking. The strong uptrend is likely to continue and even accelerate over the next 12 months. Those sitting on the sidelines will have the opportunity to start deploying cash at even more attractive valuations. With interest rates falling, and likely to continue to go down, it's one of the best times to be invested in high dividend stocks for both income and capital appreciation. With many high-yielding stocks having been out of favor for many years as growth stocks dominated the scene, it's fairly easy to build a defensive portfolio while still achieving a 9% to 10% overall yield. This market strongly favors income investors who are seeking a stable and reliable paycheck to cover their expenses and boost retirement savings.
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Disclosure: I am/we are long EPR, ET, IRM, NLY, UTG. 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.