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VOL. 38 | NO. 33 | Friday, August 15, 2014

Even in bull market, time is right for defense

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Downturns, while painful, can be very useful for the information they provide.

The S&P 500, representative of U.S. large cap stocks, declined 4 percent between July 24 and Aug. 7, and limiting our data set to this time period produces a couple of interesting observations.

First, while interest rates didn’t actually move as feared, interest rate sensitive investments did. Master limited partnerships, utilities and high dividend payers underperformed over the period.

Second, the emerging and frontier markets outperformed notably.

Therefore, the best defense during the last “mini-correction” was to overweight the emerging markets while underweighting U.S. high dividend payers. Seem backwards to you?

U.S. High Yielders

Interest rates have held near historic lows ever since the financial crisis, making stock yields comparatively more attractive. Traditional high-yielding sectors like utilities, consumer staples, real estate and master limited partnerships have attracted record amounts of yield-starved capital.

This large inflow of capital has led to relative overvaluations across these areas.

For example, when considering the ratio of valuation to earnings growth (the PEG ratio), the highest priced sectors in the S&P 500 are telecom, utilities and consumer staples.

Historically, the correlation between high dividend-paying equities and Treasury bonds approximates 80 percent. Therefore, should interest rates rise, these stocks could lack their defensive armor.

U.S. Small Caps

It’s never a good thing when the chair of the Federal Reserve comments on valuation, but that is exactly what Janet Yellen did recently before the U.S. Senate.

In her testimony, she said some small cap stock valuations are “stretched.” By many measures, U.S. small-cap stocks have reached historically high valuation levels. A closer look at recent performance expresses this valuation burden.

Small caps actually began their decline on July 1, falling 8 percent, or twice the drawdown of the S&P 500. For valuations within U.S. small cap to rationalize either earnings must grow substantially or prices must continue to decline.

Treasury Bonds

Even with all of the rate anxiety driven by the better-than-expected second quarter GDP release, the 10-year Treasury bond yield recently hit a new yearly low.

However, prior to the breakout of geopolitical disturbances, Treasury yields had begun rising in recognition of improving growth, wage and inflation data. As geopolitical anxieties recede, yields will again reflect the fundamentals.

Absent a perpetual “Japanification” of the entire global economy, yields will rise, meaning bond valuations and prices will ultimately fall.

Bottom Line

Valuations tell you very little about market direction over the short term as high valuations can go higher, and low valuations can go lower. However, when it comes to forecasting longer-term market returns, point in time valuations carry the highest predictive power.

As such, U.S. high-yielding stocks, U.S. small cap stocks and longer-dated U.S. Treasury bonds are all issuing valuation warnings.

As we venture further into this bull market, strategic emphasis should shift toward shoring up defenses. Reducing valuation risks makes a prudent first step.

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.