James Carville, the colorful political strategist also known as the “Ragin’ Cajun,” once quipped about reincarnation, “I’d like to come back as the bond market. You can intimidate everybody.”
That used to be the case.
However, with half a decade of abnormally low bond yields, investors no longer seem to fear the bond market.
That’s about to change.
The equity markets shifted to wide-open rally mode with the ascendancy of Donald Trump to the Oval Office. Warren Buffett has often referred to the stock market as a voting machine.
If that’s case, Trump won the popular vote in a landslide, with the Dow Jones Industrial Average advancing 12% since election night.
But while a 12% move in stocks always gets my attention, this stopped me dead in my tracks.
It seems that Trump’s Twitter app isn’t the only thing he’s pounding. Now, to be fair, as much as it may disappoint the President, he alone isn’t causing the 44% rise in 10-year Treasury yields.
The most likely culprit is a combination of expected fiscally expansive government policy combined with a rapidly improving economy spurred by wide sweeping deregulation. An accelerating business cycle is long term bullish for stocks.
However, bond yields climbing 44% in four months is not bullish… for anything.
Rapidly rising rates are almost guaranteed to throw cold water on any economic expansion. Basically, as businesses and consumers are prepared to borrow money to grow their business or increase consumption, they’ll be faced with higher a borrowing rate, which means that they’ll probably hold off on acting. Any potential economic growth will be dead on arrival.
But who’s to say? In the current socio-political/economic environment nothing and everything surprises me.
But with the threat of stillborn economic growth, investors should remain cautious. That doesn’t mean sit on your hands.
However, you should always keep your eye on the ball. With that directive, there are two crucial factors that should remain at the forefront of an investment strategy…
1. Valuation: Price ALWAYS matters. One of the best measures of a stock’s valuation is the forward price to earnings (P/E) ratio. A stock is purchased based on the underlying company’s ability to deliver future earnings. The current forward P/E for the S&P 500 index is around 17. While not historically high, investors looking for a bargain should aim to select a stock with a forward P/E lower than that of the index.
2. Yield: When you buy a stock, a dividend is reasonable compensation for the financial risk you are taking. Again, the S&P 500 is the example. The current dividend yield for the S&P 500 is right at 2.08%. Buying a high- dividend stock that pays out, say, 3.5% means that you are being paid 68% more than the index is yielding.
Despite the warm fuzzies the present stock market rally seems to be producing, investors would be better suited to look at these ideas.
I’m still a fan of high tech business development company (BDC) Hercules Capital Inc (HTGC), which I profiled here. I also like the tech/biotech-focused Calamos Convertible Opportunities and Income Fund (CHI), a high-dividend payer I’ve had an eye on for weeks. HTGC yields 8.4% while CHI throws off an attractive 10.3% yield.
Going back to the BDC well, Apollo Investment Corp. (AINV) complements the mix nicely. AINV specializes in debt and equity financing for higher growth companies with a diverse portfolio representing fintech, renewable energy, as well as information technology and bio-pharmaceuticals. Shares currently trade around $6.15 with a forward P/E of 9.2 and a 9.8% dividend yield.
Risks To Consider: The biggest risk is the swift back up in interest rates. HTGC and AINV rely on capital markets and leverage to raise money to fund projects. If rates go up too much, capital becomes expensive. However, BDCs typically lend to companies who are ignored by commercial banks. Their portfolio companies are accustomed to higher borrowing costs so it wouldn’t be a big deal when the BDCs pass along their higher cost. In fact, since the Financial Crisis of 2008, BDCs have become the primary lender to middle market U.S. businesses and I just don’t see that going away.
Action To Take: While the Trump rally will probably run out of gas, the rapid rise of treasury bond yields is downright scary. Modest valuations and above average yields are a good defense. As a basket, high-dividend stocks AINV, CHI, and HTGC have an average forward P/E of just 10.4, which is a 38% discount to the forward P/E of the S&P 500. Their combined yield sits at 9.56%, representing a pick-up in yield of nearly 360% from that of the index.
Editor’s Note: One stock is beating the pants off of all others. And investors who grab even a small handful of these cash-payers can be set for life with a recurring stream of ever-increasing income. To discover the strategy that’s a must-have for a cushy retirement… Full story.
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