- The era of broad growth stock outperformance is likely over, in our view.
- Our balanced portfolios are paying more attention to yield.
- We like ‘stocks that look like bonds’, and ‘bonds that look like stocks’.
T.I.N.A.’ – ‘There Is No Alternative’ to stocks- was the acronym that defined the ‘Quantitative Easing’ era, circa 2009 to 2021. TINA referred to the implicit belief that inflation and interest rates would stay low ‘forever’, leading balanced investors to own more stocks than normal. With central banks anchoring short term interest rates around zero, short-term US treasuries’ traditional role of ‘risk-free rate of return’ became instead viewed as ‘return-free risk.’ In a low-growth, low-interest rate environment, the ability to grow was prized, and thus growth stocks garnered a large premium in this era.
But the paradigm has now shifted, thanks to high inflation and tightening Federal Reserve policy. This new environment acknowledges that interest rates were held artificially low due to the Fed’s ‘growth at any cost’ mandate that no longer is required – and in fact, is now antithetical to the Fed’s most pressing mission of controlling inflation. We humbly submit a new acronym to define this new era, marked by positive and rising inflation-adjusted bond yields: ‘P.A.T.T.Y.’ It stands for ‘Pay Attention To The Yield’– and it is another way to say that we believe income generation will likely be one of investors’ best weapons against a highly volatile stock and bond market driven by tightening monetary policy and rising rates.
The previous TINA era was marked by muted nominal economic growth and even lower inflation, giving the Fed and other global central banks carte blanche to keep a lid on interest rates. This allowed a massive premium to accrue to business models which promised well above average long-term revenue growth – aka ‘growth’ stocks. If real yields move higher, we believe the demand for growth stocks will continue to decline. In its place, we expect stock and bond themes that generate durable income will find higher demand and better long-term total returns among investors.
S&P 500 Median Forward P/Es of High Dividend Yielders minus Low Dividend Yielders
Introducing PATTY…The Thrifty ‘Coupon Clipper’
PATTY is thrifty by nature, as dividend stocks generally don’t trade at a significant premium to the broad market. High dividend stocks look particularly cheap relative to low dividend yielders, which are often growth stocks. In comparing the valuation of the top and bottom quartiles by dividend payment over time, high dividend stocks have rarely been this ‘cheap’ relative to low dividend ones throughout history, going back to the 1980s (see chart, courtesy of Ned Davis Research, above).
PATTY also loves to clip coupons on fixed income investments. After the recent market downdraft, many bond asset classes now have significantly higher yields than they did at the beginning of the year (see table, below). We believe the higher yields that these PATTY securities now provide can serve as a more protective cushion to protect against additional near-term downside as the Fed normalizes interest rates. This is a theme we wrote about in our Weekly View last week.
Looking For PATTY ‘In All The Right Places’ – Quality Dividend Payers And Growers, Short-Duration Credit, And Covered Call Strategies
A key common attribute for these ‘stocks that look like bonds’ is not only current dividend payments, but the stable earnings and cash flow needed to support dividend payments in the future. We caution investors against looking for dividend love in ‘the wrong places’. To us, this includes companies with dividend payout ratios (the percentage of dividend payments that are covered by corporate earnings) above their capacity to pay. We would also express caution toward companies with high levels of debt relative to their capitalizations, and low levels of debt interest coverage. Those characteristics could make a company vulnerable if their business prospects or the economy experience a downturn.
In a PATTY world, growth-oriented stocks without discernable cash flow or dividends may remain vulnerable to further valuation downside if inflation continues to rise, as we now expect. In contrast, we think dividend generators will remain relatively attractive. We think target-rich environments for these types of US stocks exist in energy, materials producers, financials, some healthcare and selected consumer plays, and even in some mega-cap technology companies that pay and grow dividends. For long-term, more risk-tolerant investors, PATTY-style stocks can also be found overseas in geographies such as the UK, Norway, Canada, and Australia.
PATTY strategies suggest also owning ‘bonds that look like stocks’ –including shorter-duration high yield bonds, bank loans, and intermediate term corporate bonds. We think this is the type of environment that rewards sustainable alternative yield strategies that benefit from heightened volatility, such as covered call writing. All of these types of assets have been part of RiverFront’s balanced portfolio purchases over the last couple quarters.
PATTY: A Long-Term Partner, But Can Suffer Volatile Mood Swings…Use In Conjunction With Risk-Management
The PATTY strategy will require patience and emotional management by investors - after all, your dividend and coupon payments only come in a few times a year, but stock and bond prices change every day. This emotional management will prove important, because we believe the stock market will remain volatile for the foreseeable future. A heavily growth-oriented index such as the S&P 500 is particularly sensitive to the movement in rates. The valuation multiple of the S&P 500 has rerated down significantly since its highs at the end of last year, from over 22x to around 18.3x today, moving in conjunction with the rise in interest rates.
While valuation is starting to appear more attractive, the next uncertainty for the S&P 500 could be related to a corporate earnings downturn, should a recession materialize. We are encouraged by the fact that forward earnings estimates have generally been stable throughout the year, even improving throughout 2022 thus far (see our Weekly View from May 2, 2022 for more on earnings estimates). However, we are watching earnings revisions closely as a potential risk.
We suggest that investors with a shorter time-horizon pair a PATTY strategy with the use of cash and equivalents during times when market trends are primarily negative. This ‘dry powder’ can be used opportunistically to purchase PATTY assets at attractive levels after large corrections in asset prices.
- The ‘TINA’ era of growth stock outperformance is likely over, given positive and rising real interest rates.
- We believe the new era will be marked by ‘PATTY’ – ‘Pay Attention To The Yield’ - a strategy of generating income from a combination of dividend stocks in industries like energy and high-quality tech, as well as credit-focused fixed income, and alternative yield strategies.
- The PATTY era will likely remain volatile; we are keeping ‘powder dry’ by holding some cash on hand to use opportunistically during large market downdrafts.