THE BLOG
06/06/2013 09:56 am ET

Stretching for Yield Can Be Perilous

I've articulated many times over the past several months that I expect a continued rotation into high-quality and defensive stocks. I said that the economic recovery from the worst recession in many decades would be slow and protracted. The anemic pace of recovery would argue for a more cautious allocation to the more economically-sensitive cyclical stocks. At the same time, however, the Fed's seemingly endless Quantitative Easing (QE) would continue to force investors into riskier assets and make stocks (especially dividend-paying stocks) more attractive relative to bonds. Therefore, we have argued for a strategy to remain invested in stocks, but stick to the companies that offer downside protection, reasonable growth prospects, and some yield. I have said there is no need to swing for the fences in this environment.

Indeed, there is no doubt that "defensive" equities have increasingly become substitutes for bonds, especially for yield-starved investors. However, we are now seeing that there is danger in taking this approach to the extreme. Since the beginning of May, as investors have sold bonds and taken the yield on the 10-year Treasury note up about 44 basis points to 2.10%, investors have also shed stocks offering the highest dividend yields. This includes stocks in sectors such as Utilities, Telecom and Real Estate Investment Trusts (REITs). These three industry sectors have been the worst-performing from the beginning of May through today, with the S&P Utilities index dropping 10.6% and the S&P Telecom index dropping 7.0% over that time frame. According to a June 3, 2013, article in the Wall Street Journal, "Vanguard Group's $40 billion REIT Index exchange-traded fund, which has been yielding more than 3%, had climbed 19% on the year by mid-May. But in less than two weeks the ETF has tumbled 9.4%."

It should be noted that my reaction to the Fed's recent commentary was that it represented nothing new. Bernanke continues to tell us that any move to slow asset purchases would be dependent on the economic data, especially regarding the labor market. In addition, I have long believed that the Fed is laser-focused on the recovery in the housing market. If better job creation and a continued housing recovery are the Fed's major goals, is it realistic to expect a sharp policy reversal at this time? I think the answer is "no," but the recent sell-off in bonds and high-yield equities may be foreshadowing the ultimate fate of investors who stretch for yield.

My preferred approach is to remain invested but defensive. Being defensive, in this case, means limiting allocations to both the most economically-sensitive stocks as well as the highest-yield stocks. The macroeconomic risks appear to be fairly well balanced at this point: 1) the economy could deteriorate, possibly resulting in another recession; or 2) economic growth could accelerate, leading to Fed policy reversal and higher interest rates. Either one of these scenarios could be bad for stock investors, and avoiding the effects of an extreme version of either scenario may not be possible. However, the most likely scenario over the near- to intermediate-term will involve a slow-but-steady economic recovery and a fully engaged Federal Reserve. Under this scenario, investors will likely continue to favor quality and defensiveness over aggressive growth or aggressive yields.