Low-volatility dividend stocks: Taking the Long View

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This original article can be found at Legg Mason .

Post-election market shifts haven’t diminished the case for a strategic allocation to low-volatility high-dividend stocks.


What a difference a day makes.  Trump’s Nov. 8 victory set in motion a rapid change in the landscape for income investors. 10-year Treasury yields rose sharply, rising nearly a full percentage point to a post-election high of 2.632% in mid-December, reflecting expectations for faster growth and higher inflation driven by potential policy changes in Washington. U.S. stock prices also rose dramatically, putting pressure on the effective yields of dividend payers in the process.

What could these shifts mean for conservative investors who have turned to dividend stocks for income in recent years – favoring those with lower volatility?   Does that approach still make sense?

The answer is an emphatic yes. Investors’ need for reliable sources of income is still acute, which is still hard to come by without taking on fixed-income risk. And the fact we had a huge rally in stocks, seemingly out of nowhere, underscores the fact that markets can change quickly – both for the worse as well as better.

Indeed, both the global economy and financial markets have been changing rapidly since the beginning of 2016, and that trend looks to continue in the year ahead. Upcoming elections in Germany, France and elsewhere in Europe signal potentially large shifts in policy.  And second-guessing changes financial markets is complicated now by new political and financial realities; most recently, voter decisions which were expected to be negative for U.K and U.S. stocks (Brexit, U.S. election) had the opposite effect.

The potential uncertainty surrounding these changes is a reminder than one can’t take any rally for granted – and that a defensive, low-volatility approach to equity income has a strategic place in a diversified portfolio. Maintaining an allocation to low volatility stocks is thus a prudent move regardless of conditions at any particular point in time.

 

Selected Equity dividend indexes compared with selected Fixed Income indexes

Source: Bloomberg, Jan 9 2017. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Generating income

With rates seemingly on the rise, do equity dividends look as attractive?  Though yields on US bonds shot up in the aftermath of the election, yields have pulled back notably since. As of January 8, 5-, 10-, and 30-year bonds were yielding 1.889%, 2.383% and 2.973% respectively — down by an average of 21 basis points from their highs directly after the December 14 Fed rate hike.

Even so, at 3.60%, the current yield of the Dow Jones Select Dividend Index, which focuses on stocks with the highest dividend yields, is still well above the recent peak in 10-year Treasury yields,

What’s more, the anticipated policy changes that have pushed up bond yields between the election and the December 14th rate hike have yet to pass the Washington legislative gauntlet.  And however dramatic the move to peak yield of 2.632% for 10-year Treasuries may have seemed, ten-year Treasury yields haven’t been above the 4% mark in almost a decade.

So given the very real prospect of range-bound GDP growth, equity dividends in general arguably remain an attractive place to satisfy income needs – especially when one moves toward higher-quality dividend payers.

 

Preserving capital

After the recent run-up, it’s prudent to ask whether all the gains will persist. The P/E ratio of the S&P500 is 21.2x as of January 10, 2017 – a level not seen since the run-up to the Great Recession in 2008-9. And with the S&P 500 and the Dow Jones Industrial Average at all-time highs and the NASDAQ Composite above its 2000 Tech-Bubble high, some pullback would not be impossible. Since the CBOE SPX Volatility Index (VIX) at 11.72 as of January 10, 2016, near its 2006 low of 11.27 and its 20-year low of 9.89 on January 24, 2007 at the beginning  of the run-up to the Global Financial Crisis, there could plausibly be more room for downside than upside.

In a year where investors have come to expect the unexpected, downside capture – the degree to which an investment strategy outperforms its benchmark during market declines – has become a key concern for the risk-averse.

For such investors, a focus on profitable companies that exhibit low price and earning volatility is a reasonable way to participate in equity market upside while managing downside moves. Additionally, a focus on higher-yielding names with solid earnings can also lead to more attractive valuations, and potentially smaller downdrafts, in what many consider to be an overbought high-dividend market sector.

 

Ready for choppy waters ahead

Despite the recent outpouring of optimism, the year ahead could well be marked by uncertainty as the new regime in Washington moves forward with new policy prescriptions. Given the unprecedented changes ahead and the current state of financial markets, it might make sense to prepare for stormy weather while the skies are clear, rather than waiting for the waves to rise – by maintaining a prudent allocation to low volatility strategies as part of a broadly diversified portfolio.

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