The stock market is a funny place, especially if you’re a value investor. In a way, if you look to buy valuable, reasonably priced stocks, part of you wishes for an irrational market. This is especially true if you’re a dividend player and you are hunting for a great entry point for a valuable and reliable stock.
Last week, the stock market was the kind of irrationality that value investors patiently wait for. Wednesday was when the real action started: U.S. stocks fell as investors panicked about the Congress’s inability to compromise with a newly elected President Barack Obama on the fiscal cliff. And so the S&P 500 fell off its own cliff on Wednesday, with the S&P 500 SPDR (SPY) losing nearly 1.5% on Wednesday as investors pulled out and covered margins amidst worries that the disastrous budget cuts baked into the fiscal cliff caused an economic meltdown that would cause stocks to fall further.
This was an irrational move, and it proved the term “smart money” wrong. Several of these sell-offs were by institutions–it wasn’t a matter of amateurs panicking. It was the so-called smart money, begging the question of exactly how smart this money is.
The even smarter money was busy buying into this market dip, and value investors of the Warren Buffett variety were looking for the bargains that, for most of 2012, simply haven’t been there. For most of 2012, large-cap U.S. stocks have seen a meteoric rise. This trend was the result of two dominant drivers, both of which are important enough to warrant a separate discussion.
The Never-ending Quest for Yield
Since the subprime mortgage crisis, the Federal Reserve has kept bond yields low–so low, in fact, that there’s little reason to invest in them unless it’s your fund’s mandate. One year Treasuries are yielding 0.16%. In January 2008, they were yielding 3.17%. That lower rate has lowered the tide for all investment instruments, making it harder to earn a return from investments in municipal bonds, junk bonds, and other government bonds tied to the Treasury yield curve.
The quest for yield has caused several asset classes to appreciate in recent years, in particular junk bonds, REITs, and municipal bonds. Junk bonds, as riskier alternatives to federal government bonds, always earn more than Treasuries, but the spread between the two has had room to shrink as Treasuries fell. This means junk bonds have become a riskier yield play since 2008. At the same time, several investors have turned to them in the quest for any type of yield, so junk bonds have gone up substantially since 2008. If you look at the SPDR Barclays Capital High Yield Bond ETF (JNK), the price of these assets has risen about 40% since the late 2008 crash, but JNK is still yielding nearly 7% dividend returns. Some investors see a junk bond bubble and are placing bearish bets on the market–Bloomberg reported yesterday that there is a record volume of bearish bets on these junk bonds as investors await a bursting bubble. Yet demand for high yield has kept prices up, despite market pessimism.
Then there are REITs, a complicated and diverse asset class. Despite famously drawing negative sentiment for the higher tax burden on dividends (which are taxed at the normal rate and not at the lower capital gains rate), REITs did well in 2008-2009 amidst a real estate crisis from which many REITs seemed immune. In particular, mREITs have grown tremendous attention since many of them offer dividend yields of 13% or higher. REITs like American Capital Agency Corp (AGNC), which invests only in U.S.-backed mortgages, are offering 16% dividend yields and are up over 55% from pre-crash levels. Few stocks can boast price appreciation since 2007, let alone a fund with a $10 billion market cap.
REITs have remained popular, and even AGNC’s recent dividend cut and lower operating margins haven’t phased investors looking for yield. So the stock is up over 10% YTD even after a dividend cut in the first quarter of the year.
The Flight to Safety–of a Different Kind
Less lucrative dividend stocks like AT&T (T), Verizon (VZ), and Procter and Gamble (PG) have attracted a fair amount of attention in 2012, even if their yields are a fraction of what the junk bonds and REITs offer. Still, they have attracted substantial attention because they are more stable, reliable, and promising dividend payers. Plus, unlike the REITs and junk bonds whose dividends have a history of going down, these stocks have a history of dividend increases which, in some cases, goes back 30 or 40 years.
For investors looking for value, yield, and safety, large-cap stocks were a no-brainer, which is why the slow and stable-growing companies outperformed their fundamentals for most of 2012. Investors wanted yield, they wanted to be in what looked like an improving U.S. economy, and they wanted safety. A profitable bet on the U.S. isn’t possible with low-yielding Treasuries, and the junk bonds have seen unsustainable appreciation, making large-caps the only reliable game in town. It’s no surprise AT&T soared 23.21% by the end of summer, and the large-cap and large-cap dividend ETFs were up comparably–DLN was up 13.27% and IVW was up 17.67% YTD by the end of summer. Fiscal cliff blues erased some of those gains, but they are much healthier than small-caps, which have been (possibly unfairly) beaten up in 2012.
About Last Week
Smart value investors were buying ravenously last week, and the more pessimism there was on the market about macroeconomic conditions, the hungrier value investors got for yield. To demonstrate this, consider AT&T. An investor who bought shares of the telecom giant on Friday when the market dipped its lowest is now looking at a dividend yield of 5.7%. That’s much better than momentum investors who bought in early October and have a dividend yield of just 4.9%.
Moments like this are the opportunities that value investors patiently wait for. Perhaps the best moment in living memory for dividend capture was early 2009, when even the most reliable players were suddenly offering dividend yields north of 8%. That opportunity may not come again for a long time–but it will. And dividend hungry value investors will be there, ready to get rich off of market fear.