Each week, we tap the insight of Sam Stovall, Managing Director of US Equity Strategy for S&P Capital IQ, for his perspective on the current market.
For more from S&P Capital IQ, be sure to visit www.getmarketscope.com.
EQ: Markets usually like to rise into the holidays, and heading into Memorial Day weekend, the S&P 500 was able to bust through that rusty door and close above the 1900 level for the first time. Based on what the market usually does when it manage to crack through a meaningful handle like this, can we expect more room to run?
Stovall: I think we should have a bit more upside to go. I don’t know exactly where that level would be, but from a technical perspective, we think the 1920 level on the S&P 500 represents a formidable level of resistance.
Based on a measured move off of the most recent breakout. I think there will come a point in which the market needs to pause to catch its breath, and maybe even surrender some of its recent gains before it can move even higher.
Right now, I think the market is feeling a bit exuberant based on the economic data confirming that much of the weakness was likely the result of bad weather early in the year. Now that we have entered into a period of favorable weather patterns, consumers and businesses will likely make up for lost time.
EQ: In this week’s Sector Watch report, you took a look at the performance of low and high yielding dividend stocks and their performance against the broader market since the introduction of the Fed’s “taper” strategy. Up until that point, investors had fallen in love with dividend stocks. What happened after that point?
Stovall: I think that investors still have fallen in love with dividend stocks, mainly because income-oriented investors continue to be starving for yield, especially now that the bond market is going through a countertrend rally in prices. That pushes the yield lower. So with the yield now being 2.5 percent versus the end-of-year level of 3 percent, investors are looking toward higher-yielding stocks all the more.
However, I wanted to remind investors that they might want to be a little more careful when adding to their holdings of high-yielding issues. When I say a high-yielding stock, I’m looking at a yield of 2.5 percent or higher, versus a low-yielding stock, which would be 1.5 percent or lower.
So I wanted to remind them that the return over the past year for high yielders has been about half of what was found for low-yielding stocks. High-yielding stocks have gained about 8 percent whereas low-yielding stocks have gained more than twice that. In addition, about 25 percent of these high-yielding stocks were still below their levels seen a year ago as of May 27.
So you have an awful lot of stocks that are still underwater in price even though investors had been gravitating toward them for the attractive yield.
So unless you don’t mind your stocks going down in price, and you are focused exclusively on yield, I would advise investors, when screening for high-yielding investment candidates, don’t yield to temptation by turning a blind eye to valuations and volatility.
Look for a yield of 2.5 percent or more, with a beta of 1.0 or less, as well as a P/E on forward estimates of about 15 or lower. Make sure you are looking at the fundamentals as well as the yield.
EQ: If interest rates are rising and inflation is expected to increase, how do dividend payers tend to react to that kind of environment?
Stovall: Historically, stocks in general tend to do relatively well in a rising interest-rate environment because investors will be adversely affected by the seesaw nature of bonds. If rates rise, then prices fall, and some investors who either leave the bond market or choose not to add to their holdings in bonds will look to the stock market. The reason is because what’s causing rates to rise is a pick-up in activity, which should translate to earnings and an increase in underlying share prices.
The higher the dividend yield the less likely the stock is going to move dramatically higher as it is more likely to be associated with a bond, and could be held back by the higher interest rates. Let’s remember that high-yielding companies are usually mature companies with relatively high debt levels and high payout commitments. So the higher interest rates go, the greater the interest expense that these companies will have to endure.
At the same time, if investors feel that rates are rising to a point where bonds might start to look attractive again, then they could end up leaving the more risky higher-yielding stocks and gravitate toward the lower volatility bonds.
EQ: Is this underperformance a result of dividend stocks getting ahead of themselves?
Stovall: I think it was more of the effect of higher rates pulling back their price appreciation. The average P/E ratio for stocks on the S&P 500 yielding 2.5 percent or more is 18.4, compared to an average of 22.4 for those companies yielding 1.5 percent or less. So in the past year, the lower-yielders have done better pricewise but they’ve seen a pickup in their P/E ratios at the expense of the higher-yielding companies.
So again, you have to be very careful and make sure you’re looking at both the dividend yield and fundamental valuations before making a decision whether you are focusing on a high-yielding or low-yielding investment.
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