Climbing the Wall of Worry Again

The broad markets are worried. I have read that statement and used it the last month to describe the current market activity. The challenge is remembering that the market is investors. Thus, the investor is worried relative to the lack of clarity looking forward. For me that means the probability of growth has less of a chance than the probability of slowing for the overall market indexes. That worry will keep me from putting capital to work and/or it will prompt me to take some money out of harms way and raise my cash allocation.

As we have discussed in our Sector Watch Updates volatility has picked up just enough to keep the attention on the uncertainty, but not cause a panic. The VIX index has risen from 14.25 to 18.65 since hitting the high on the S&P 500 index on April 2nd. A move above 21 would garner bigger concerns if it accelerated through that level short term. For now, the index is an accurate reflection of the nervousness relative to the broad markets and investor concerns.

If money is rotating away from higher risk assets, where is it going? Cash is the primary winner along with short term bonds, which I would call a cash equivalent. There are other areas benefiting from the lower risk scenario the greatest of which is dividend stocks. It sounds crazy on the surface to say money is seeking less risk by rotating to dividend stocks, and I agree with you. However, the story is being sold by Wall Street. Remember, they make money by keeping your money invested, not holding cash. You can pick up any financial periodical or land on their websites and the topic of choice is dividend paying stocks. Thus, the story or pitch to buy the dividend and wait or hold for the growth is attracting money from investors. It is easy to understand why when the yield on short term bonds is 0.7% and you can buy Proctor & Gamble with a 3.4% dividend and upside growth opportunities over the longer term. Or at least that is storyline.

Without getting into the particulars of risk/reward relative to this scenario let’s just keep it simple. The difference in buying a short term bond and a dividend stock are not even on the same planet. If you are comfortable with the risk to dividend yield of the stock then buy it. But, to buy it because of the dividend without regard to risk doesn’t make sense. Off that soap box and back to the purpose at hand, where do we allocate or deploy our cash for the greatest yield to risk opportunity? The answer really depends on the risk you are willing to accept now and over what time-frame.

The short term bond yield I mentioned of 0.7% comes from SHY, iShares 1-3 Year Treasury Bond ETF. The risk is the short end of the yield curve moving higher. Recently the volatility in the stock market has pushed money in the direction of bonds and thus the yield has decline which in turn has pushed the price higher. Thus, this offers a low yield-to-risk opportunity for parking cash short term. The upside is limited, but the downside is as well. Thus, accomplishing the goal of lower risk to money in the current market environment.

Stepping up on the risk scale is LQD, iShares Investment Grade Corporate Bond ETF. The duration and maturity length of the bonds increases the risk or downside if yields on bonds rise, in addition we introduce credit risk into the equation. For increasing the risk we get the a high dividend yield of 4.2%. If money is rotating towards safety, yields generally decline. That favors bonds and thus the fund would move up in price as well as pay the dividend. That is the perfect scenario! There is still increased risk in buying the fund. If sentiment shifts back to stocks being the investment of choice and money rotates back in that direction, the yields would rise short term and the fund would decline in value. The decision is based on your belief relative stocks near term, time-frame and risk acceptance. You are moving away from the original objective based on the current market environment. You would now have to make this decision as an investment choice not risk avoidance.

We could venture further out on the risk scale and consider high yield or junk bonds on the corporate side. The dividend would be above 6% currently, but you are introducing a greater level of risk. If we are attempting to avoid the risk of an uncertain market this not likely the choice to make. This would be an investment choice for an asset class in our portfolio not risk avoidance.

The simple point I am making is don’t get side tracked from your original objective. The market is adjusting short term in relationship to stocks. The volatility has increased due to uncertainty short term. That prompts the natural response of lessening the risk in my portfolio by taking some or all my money out of stocks. Putting that money back at risk in a different way makes little to no logical sense. Find the best choice based on the objective. In this case lessen risk exposure to stocks and see how it plays out. Cash is a sector and offers the greatest protection against mark downturns. Invest your money based on the objective and time-frame you are considering not what others say or allowing greed to seduce you and lose sight of the original goal.