By keeping interest rates near zero for such an extended period, The Federal Reserve has forced the large population of savers to look for returns in more aggressive areas. Those savers, which as a percentage are mostly retired, simply cannot get by when their income has been reduced to nearly nothing from the average 4-5% returns of prior decades.
As a result, the search for a higher yield has forced them to take on more risk than usual by purchasing higher yielding bonds from lower rated companies and most recently, purchasing stocks just for their dividend returns. So much of this money has been moving to these types of investments over the past few years that they are becoming overvalued by historic measurements. In spectacular fashion, high dividend stock mutual funds and high yield bond funds have returns in the mid-teens year to date. The S&P 500 stock index and the Dow Industrials are up less than 5% by comparison.
These dividend stocks have grown so fast they are getting quite expensive. A search of the top yielding Exchange Traded funds reveals that the average price-to-earnings ratio is now 26 times earnings where the past 10 year average is 19 times. Investors are none-the-less ignoring this reality and continue to buy up shares increasing the overvaluation.
Adding to the money flow to higher yielding funds is the practice of index funds and robo-advisors that use mechanical strategies that follow current market outperformers. This has pushed large sums of money toward dividend stocks because they have done well.
Investing for yield is not a bad strategy as long as it is just part of a strategy and the risks are known. Overvaluations in markets tend to become their own catalyst, and then it corrects. This past quarter, we have witnessed prices for high dividend retreat as the Federal Reserve talks about raising interest rates in December. If the Fed continues to keep rates at this low end and not raise them, this shift to higher yielding assets may continue. Eventually though, they will return to normal valuations and take many savers with them.
Switching to the more growth-oriented stocks and funds; there appears to be a good case building for the resumption of growth in this category. There has been quite a contrast between the double-digit returns recently in the high dividend companies and the barely positive returns of the growth sector. Our experience tells us that money flows between the various sectors as conditions in the economy, and specific companies, change. This time will be no different.
Current indicators seem to be leaning towards conditions that can attract money flowing back into growth stocks. Investor cash is at all-time highs, so far this earnings season 80% of companies reporting have beaten estimates, the S&P 500 price earnings ratio has retreated to its normal value of 16 times earnings, and China’s economic GDP is rising. The large amount of sales by investors out of Growth mutual funds this year and also the low bullish sentiment of investors are nice contrarian indicators.
Obviously, investors all have varying circumstances and goals that they are attempting to achieve. Amounts of assets allocated to the different market sectors should be determined by those goals and objectives. To try to time the precise movement of money either going into or out of these various investment choices most likely will lead to disappointment and loss.
While there are many issues that are of concern to us as a country and an economy, there are endless opportunities coming our way that will enrich both our daily lives and our net worth. Let’s plan for them!