Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: The market has bounced up pretty nicely over the past two weeks after falling over 5 percent for the week immediately following the election. With the market up about 9.5 percent year-to-date, what is the likelihood of an end-of-year rally as we approach December?
Stovall: I think the likelihood is pretty good because in the election years since 1900, whenever the incumbent has been reelected, the market was up about 1 percent in November and gained in price a little less than 60 percent of the time. In addition, it was up about 3 percent in December and rose in price 75 percent of the time. So if you look at the entire two-month period, the average increase was 4 percent and the frequency of an advance was two out of every three years. So I would tend to say that the likelihood of a year-end rally remains fairly good.
EQ: Investors still have major headwinds to deal with both at home in the U.S. as well as overseas in Europe, the Middle East, and Asia. Given that many of the major issues have been ones that were dragged out for quite some time now, would you say that the potential upside from solutions could outweigh the possible downside of economic catastrophe?
Stovall: The market definitely has a fairly high wall of worry that it’s staring at. Yet, that wall itself has been the same one we’ve been staring at for an extended period of time—tension in the Middle East, combined with worries about the European debt crisis, and Europe falling into recession, as well as a harder-than-expected landing in China. These factors have been in play for such a long time, I don’t think they are going to materially affect the direction of the market in the near term. What is of paramount importance to investors, however, is the two words that people are very tired of hearing, and that’s the “fiscal cliff.”
Investors realize politicians are probably better at drama than William Shakespeare and that some sort of compromise would likely come at the 11th hour. Yet, investors also believe that there is a possibility we will fall off the cliff, and the Bush tax cuts will expire come early January 2013 along with the sequestration. So investors, while they believe there’s a greater chance of some sort of agreement coming forth before year-end, realize that there’s also a fairly large risk that we won’t. Because of that, I would tend to say that the worries over the wrangling in Washington outweigh almost any of the other worries out there today.
EQ: It seems like the market is getting back to the manic, up-and-down trading based on mixed messages coming out of Washington. We had the market edge lower Tuesday based on Harry Reid’s comments, now up apparently on optimism from President Obama and John Boehner. Do you have any advice for investors tracking the progress of deal talks?
Stovall: You have to put this volatility into perspective. The Volatility Index (VIX), which is a fear gauge based on options transactions, is actually relatively low, implying that from a professional standpoint there’s not a lot of fear out there. Also, if you look at a rolling 20-day chart to see the number of times the market either rose or fell 1 percent or more in a single day, it seems we’re actually equal to the average since 2000. If you indicate that risk is volatility in excess of 1 percent, then right now, we are experiencing an average amount of daily risk.
So my recommendation is basically if you are a buy-and-holder, then buy, hold, and close your eyes. Or, at best, turn off the TV set because TV and radio companies, as well as print media, are paid to create excitement. There’s the old saying, “If it bleeds, it leads,” The reason is because bad news sells. So sensationalism is stock and trade of the financial media, because otherwise, how would they get you to turn on the tube again come tomorrow morning? Investors should look at the indicators and the price performance of the market, and try not to pay that much attention to the headlines.
EQ: Is it possible that some of the market movement is misattributed to the fiscal cliff comments and maybe is being driven by something else that investors may be missing if they’re just paying attention to the headlines?
Stovall: I think that’s certainly a possibility. There was a music group from the late-60s called Chicago and they had a song called Does Anybody Really Know What Time It Is. I feel that the same could be said about the factors that drive the overall market. Do we really know if it was Senator Harry Reid’s comments that drove stocks up and down? Sometimes they can make a pretty good guess based on when the comments were made and then look at what time the market posted a precipitous decline. But many other times, people just don’t know why the market did what it did but they simply come up with what they think is an intelligent reason. But do we really know what caused people buy or sell on that specific day? Unless you ask everybody, you really won’t know.
EQ: Some of the implications for higher taxes on investments had investors moving out of dividend stocks in droves. Why is this a bad investment decision?
Stovall: My belief is that you’re probably not better off bailing out of stocks now only to get back into them in early January based on wanting to lock in the lower dividend and capital gains tax rates. Unless you really planned on selling these issues anyway, all that it’s really going to do—especially if you have a really low cost basis on these items—is push up your taxable income this year and force you to replicate the amount of taxes that you’re paying next year, or otherwise risk a penalty because you don’t pay enough taxes.
Also, the U.S. has gone through a multitude of changes in the tax laws and sticking with good, quality stocks over the long haul has remained a cornerstone of successful investing. In a recent report that I wrote, I said it’s still OK to look for stocks that pay a dividend yield of 3 percent or more because you are getting a yield that is almost twice that of the 10-year Treasury note. You’re also, by default, buying into companies with lower volatility because it’s usually the larger companies from fairly defensive sectors that end up paying an attractive dividend yield. You can also get a second opinion by looking at the S&P Quality Ranking for earnings and dividends of A- or better, which implies that a company has had an above-average track record of raising their earnings and dividends in each of the last 10 years.
Also, you can add to your comfort level by only selecting those high dividend paying stocks with good quality rankings that have favorable investment recommendations too, because very few analysts on the Street are willing to put a buy recommendation on a stock if they believe the dividend is likely to be cut.
EQ: So using that set of criteria, what are a few examples of these kinds of companies?
Stovall: So in a sense I took my own advice and I performed a screen on S&P’s MarketScope Advisor to decide which stocks are worth buying. I looked for three things: the past, present and future. First, looking to the past, I screened for all the companies that have an S&P Quality Ranking of A- or better. Since a B+ is average, an A- or better means these companies are above average. For the present, I looked for companies that paid a yield of 3 percent or more. Then for the future, I screened for companies that have favorable investment recommendations, meaning S&P STARS of 4 or 5 (buy or strong buy, respectively).
I came up with companies in eight of the 10 sectors within the S&P 500. The two sectors that were excluded were Materials and Information Technology simply because we did not have stocks that had buy recommendations with the other two criteria. There were companies that have a good track record of raising their earnings and dividends, and had a dividend yield of 3 percent or more, but none of them had favorable investment recommendations.
But for those that did show up:
In Consumer Discretionary, we have Darden Restaurants, Inc. (DRI), which has a buy recommendation, an A quality rank, and a dividend yield of 3.8 percent. We think that if tax rates go up, consumers might end up looking toward the more cost-effective restaurants. Darden fits that bill.
In Consumer Staples, we had the largest number of companies that passed the screen. General Mills, Inc. (GSI), Kellogg Company (K), and Pepsico, Inc. (PEP), are good quality companies with long track records of raising their earnings and dividends, and had buy recommendations.
In Energy, Chevron Corp. (CVX) is a company that’s been beaten up the last several months. We have a strong buy recommendation on it, and it has an A+ rating, which is the highest quality ranking. It also offers a dividend yield of 3.4 percent. Two more names that have strong buys are Microsoft Corp. (MSFT) in Technology and UGI Corp. (UGI) from Utilities.