Why high yield stocks now look the best bets

From David Stevenson, across the river from the City

Dear Money Morning Reader,

It's been a great summer for shares. On Friday, the FTSE 100 index hit its highest level since last October.

We don't think the rally can continue for much longer. With signals from the "real world" economy mixed at best, it's only a matter of time before the bulls are brought down by the weight of disappointing data.

However, that doesn't mean there aren't any bargains out there. Despite the surge in overall share prices, some very sound companies – those best-placed to withstand a "double-dip" recession in fact – have been completely neglected by the market. And even better, you get paid well to hold them too…

Too many bulls around for comfort

When everyone gets bullish, it's normally time to head for the exit.

In last Wednesday's Money Morning, we served up five reasons why stock markets are now looking very toppy. To start with, there's the track record of the Investors Intelligence (II) weekly poll of American stock newsletter writers.

It's the classic contrarian indicator. Whenever the II survey shows investors getting the glums, you should buy the market. And when sentiment turns big-time bullish, it's time to get out. So the latest reading, showing the lowest level of gloom since the US market peaked in October 2007, together with the highest optimism level since January 2008, just before markets plunged, isn't good news for shares.

More concerning is that the Bank of America Merrill Lynch (BoAML) survey of 200 leading institutions has just served up more of the same. A net 75% of fund managers see the world economy improving in the next 12 months - a six-year high. And, it seems, there are now more stock market fans around than at any time in the last two years.

Now, BoAML says the optimism is only "skin deep". Apparently 80% of these investors reckon the recovery will be fairly feeble. Yet despite this, the surveyed fund managers still said that they've run down cash levels from 4.7% of their funds in July to a mere 3.5% in August. All that money's gone into shares. A net balance of 34% of respondents was 'overweight' in equities – i.e. they held a higher percentage than the benchmarks against which they're measured - up from just 7% a month before.
Stock markets are heading for a fall.

There are two conclusions: firstly, global stock markets, led by Wall Street, are riding for a fall. And secondly, some sizeable stock rotation is in store: fund managers' favourite shares are set to start changing.

Look at the chart below, which covers the period from late 1999 to the present.

The blue line shows the relative performance of the FTSE Higher Yield index, which tracks stocks paying above-average dividend yields, compared with the FTSE Lower Yield index, which also does what it says on the tin, over the last 10 years. The red line is the FTSE 100 index.

When the 'dotcom' bubble imploded at the turn of the millennium, investors were forced to start focusing on businesses that made and sold real things (and in turn paid real dividends), rather than profitless, dividend-less tech stocks. But in the years since the market bottomed out (around about March 2003), high-yielding stocks have steadily fallen out favour. They've now fallen to their lowest relative performance level for eight years.

But note how the relative performance of high-yield shares moves in the opposite direction to the overall market. High yield stocks tend to be on cheaper valuations than low yielders, while decent dividends are a great help in supporting share prices.

High-yield income stocks should still perform well

If the FTSE 100 drops, income stocks are likely to do comparatively well as fund managers switch into them to protect their portfolios. And if the index does hold up, you get well enough paid by high yielders to make them a good bet anyway.

"The rally has been driven almost entirely by multiple expansion, most obviously at the low-quality end of the market", says Morgan Stanley. "Now is the time to look again at high quality, high yield". Note the "high quality" part. As we also pointed out last week, Britain's about to face a dose of dividend downgrades. The overall payout level this year is likely to be some 13% lower than last year. So you need to hold high yield stocks where the dividends also look safe.

We've been banging the 'defensive' drum for quite a while now. Defensive stocks, like telecoms, utilities and pharmaceuticals, don't depend on economic growth for their profits, so they're likely to be the 'go to' sectors when the big income switch starts.

Until next time,

David Stevenson

Associate Editor, MoneyWeek UK
 
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Turning to the markets...

The JSE all share index closed down 0.35% yesterday. The gold mining index climbed 1.14%. Resources shed 0.27%. Banks and financials added 0.52% and 0.05% respectively. Industrials lost 0.71% and the platinum mining index gained 0.57%.

London’s FTSE100 closed up 0.42%. The Dow Jones added 0.32% and the Nasdaq gained 0.31%.

Tokyo’s Nikkei closed 0.79% down. Hong Kong’s Hang Seng climbed 0.46%.

Brent crude is currently trading at $71.90 per barrel.

Spot gold’s trading at $948.15 and platinum was last quoted at $1,248.00.

And here’s how the rand is performing against the major currencies:
R/$7.80
R/£12.74
R/€11.16