Month: August 2015

Market Perspective: Domestic Markets Remain Resilient Despite Concerns Overseas

Equities were mixed over the past month, with the Nasdaq leading the field with a 2.08 percent return, followed by the S&P 500’s gain of 1.33 percent. The Dow Jones Industrial Average fell 0.82 percent, while the Russell 2000 Index dipped 2.34 percent. These moves were insignificant compared to the volatility in the commodities market, where oil fell to its 2015 lows and threatened to break lower. Further pain was felt when China devalued the yuan and paved the way for even more devaluation over time.

China’s decision to weaken the currency is an admission that the yuan was overvalued versus the U.S. dollar. Relative to other currencies, the yuan has been rising since July because it is closely pegged to the U.S. dollar. The greenback has been in a bull market since July of last year, and the yuan piggybacked on that move. While the U.S. remains in an expansionary cycle, China has entered a contractionary one. This currency appreciation dealt a triple blow to China.  Its exports became more expensive as the dollar rose against export competitors such as Europe, Japan and other emerging markets. Emerging markets were the main growth engine for exports, but many of those economies are resource dependent. The U.S. dollar rally accompanied a bear market in commodities, severely impacting economies such as Brazil. Finally, a slowdown in reserve growth led to a contractionary monetary policy in China.

Commodities sold off on the news of the devaluation, and the next shoe to drop may include other Asian currencies, most importantly the Japanese yen. West Texas Intermediate Crude oil fell to a new 52-week low, joining commodities such as copper and iron ore at multiyear lows. The euro rebounded on news of a new deal “in principle” for Greece. Details still need to be added, and the Greek parliament must approve the agreement.

While there was turmoil in the commodity and currency markets, domestic markets benefited by being a safe haven for investors. The 10-year Treasury yield edged down from 2.5 percent a month ago to 2.2 percent. If a move toward the U.S. dollar continues, the Federal Reserve will have room to hike short-term rates without worrying about a significant increase in long-term rates. In fact, a rate hike by the Federal Reserve in the current environment could exacerbate some of the weakness seen overseas and in commodities, pushing long-term yields lower even as short-term rates rise.

As for the U.S. economy, it remains on sound footing. Second-quarter GDP growth came in at 2.3 percent. The Atlanta Federal Reserve GDP Now model increased its GDP estimate throughout the quarter as stronger data was released. The trend points to a possible upward revision when the second estimate is released in late August. Unit labor costs increased 0.5 percent in the second quarter, down from a revised 2.3 percent in the first quarter, but up from forecasts of a 0.1 percent decline. The Federal Reserve is most concerned about labor costs, and the rise, while small, pushes the Fed closer to a rate hike. Along with rising labor costs, jobless claims hit a four-decade low in July, payrolls are steady and income growth is solid.

Amazon (AMZN), Google (GOOG) and Netflix (NFLX) were among the companies rewarded with double-digit gains following strong earnings reports, while Tesla (TLSA) and Keurig Green Mountain (GMCR) were hit with double-digit losses. The Dow Jones Industrial Average was a victim of these earnings-related stock losses. Caterpillar (CAT), Disney (DIS), Procter & Gamble (PG), Exxon (XOM), Chevron (CVX), United Technologies (UTX) and International Business Machines (IBM), as well as underperformance by Apple (AAPL) and DuPont (DD), weighed on the index. Disney also sparked concerns across the entire media industry as investors worried about how competition from Netflix, Amazon and other streaming services would impact its future growth outlook.

With nearly 450 companies in the S&P 500 having delivered second-quarter earnings, FactSet Research reports earnings have fallen 1.0 percent from a year ago, with nearly all of the decline due to the energy sector. Fifty-one percent of firms beat sales estimates, while 73 percent beat earnings estimates. The energy sector reported a 56.4 percent decline in earnings thus far, while industrials, which may be suffering partially from lower spending by energy companies, reported a decline of 4.8 percent. In contrast, the healthcare sector remains the market leader in terms of performance and earnings, reporting growth of 15.4 percent, more than double analyst estimates. Consumer discretionary, telecom and financials were the next three strongest sectors for earnings.

Strong earnings, solid economic growth and instability overseas are positive for U.S. asset markets. The main risk to equities over the coming month will be from commodities or currency markets. Many shale oil producers will face bankruptcy concerns if oil prices dip into the $30 range, due to large borrowings used to finance capital investments. A currency crisis in emerging markets is possible for similar reasons; many companies borrowed in U.S. dollars, expecting the currency to fall, but if the greenback surges to a new high, defaults could rise. The U.S. economy is insulated from emerging market currency troubles, but the financial markets are global. If investors start selling overseas, there is likely to be some spillover into the United States and other developed markets.

Fund Spotlight: Vanguard High Dividend Yield Index (VYM)

In the wake of the commodities sell-off, yields on energy giants such as Chevron (CVX) and Exxon (XOM) have reached 5 percent and 3.7 percent, respectively. Income-oriented investors are no doubt tempted by those yields, but analysts are concerned about the dividend payments from ConocoPhillips (COP), which yields 5.9 percent at recent prices. The primary risk for these energy companies would be falling oil prices, which would squeeze their ability to pay investors while making capital investments. Without those investments, future growth, and hence future dividend growth, would be at risk. In order to avoid that sector-specific risk, investors may want to consider diversified dividend funds as a better option than individual stocks.

The Investor Class Vanguard High Dividend Yield Index Fund (VYM) is a large-cap, no-load mutual fund that seeks to track the performance of the underlying benchmark FTSE High Dividend Yield Index. It employs an index investing approach by allocating most of its assets in stocks that make up the index. These stocks are common shares issued by companies that pay a higher-than-average dividend. The fund’s low cost and historical performance earn it a Morningstar Analyst Rating of Silver. There is also a mutual fund class of this product, which trades under the ticker symbol VHDYX. Approximately 75 percent of the $16 billion in assets under management are held in ETF shares.

Investment Strategy

The fund’s market cap-weighted portfolio comprises more than 400 U.S. stocks that have been selected based on their yields. It has been led by Michael Perre since its inception in 2006, and its managers shy away from small- and mid-cap stocks that may offer greater returns but are also inherently more risky. The passive, market cap-weighting investment style reduces turnover. At 17 percent, the fund’s turnover is well below the 55 percent average for the large value category. Broad sector diversification mitigates risk.

Dividend-paying stocks are seen as defensive because they have outperformed non-dividend-paying stocks since 1926. The fund is not without risks; some companies that pay higher dividends can become distressed and cut their payments. To reduce this risk, the fund managers tilt their investments toward large global conglomerates with competitive advantages, such as Exxon Mobil, General Electric (GE) and Johnson & Johnson (JNJ), while avoiding potentially riskier names like Freeport-McMoRan (FCX). That strategy has paid off; FCX has declined 58 percent since May, while XOM has lost only 13 percent. VYM is fully invested in the market at all times.

The fund tracks the FTSE High Dividend Yield Index, which is composed of dividend-paying stocks excluding micro-caps, MLPs and REITs. The managers sort stocks by dividend yield and add to the index starting with the highest-yielding issues until the index portfolio’s market cap equals 50 percent of the market cap of all dividend-paying stocks. The index is then market-cap weighted. The result is a value portfolio that encompasses approximately 38 percent of the total market.

Portfolio Composition and Holdings

The fund has a 98.53 percent exposure to domestic shares, a 0.86 percent exposure to foreign stocks and a less than 1.0 percent cash position. With an average market cap of $73 billion, VYM has 58 percent of assets in giant caps as well as a 27.37 percent, 10.48 percent and 3.12 percent allocation to large-, medium- and small-cap shares, respectively. The mutual fund is overweight the consumer defensive sector, while underweight real estate and consumer discretionary. The portfolio has a P/E ratio of 16.66 and a price-to-book of 2.25, higher than those of the Russell 1000 Value Index. Stocks within the portfolio have an average dividend yield of 3.4 percent.

The fund has 30.48 percent of assets in its top 10 holdings. These include Exxon Mobil, Microsoft, Wells Fargo, Johnson & Johnson and General Electric. The next five in descending order are JPMorgan Chase, Procter & Gamble, Pfizer, Verizon and AT&T. It also holds 53 percent of assets in shares that have a wide Morningstar Economic Moat Rating, which compares with the category average of 37 percent.

Historical Performance and Risk

The fund’s managers have done their job well as VYM has less than a 10-basis-point tracking error. From its inception through April 2015, VYM has returned an annualized 6.9 percent. Although this is less than the 7.1 percent of the S&P 500, value has underperformed during the past decade. On the plus side, the fund has a lower standard deviation.

Over the same period, VYM beat the large value category’s average return of 5.1 percent. For its past 1-, 3- and 5-year periods, VYM has generated average return of 7.44 percent, 14.11 percent and 15.23 percent, respectively. The comparable category averages were 5.98, 14.55 and 13.04 percent. VYM has a 30-day SEC yield of 3.22 percent, while VHDYX has a 30-day SEC yield of 3.15 percent.

Risks, Fees and Expenses

The four-star Morningstar rated VYM has no minimum investment, but VHDYX has an initial minimum investment of $3,000. The fund has an average Morningstar risk rating with its 3-year beta of 0.90 and a standard deviation of 8.64. This compares with the category beta and standard deviations of 0.98 and 9.03. The expense ratio for VYM is 0.10 percent. VYM has a net expense ratio of 0.18 percent, with no 12b-1, initial, deferred or redemption fees.

Outlook

VYM has seen a net inflow of $10 billion over the past five years as dividend-paying stocks have become increasingly popular with income investors. VYM may experience a sharp pullback if interest rates rise or there is a major sell-off in the market that causes investors to give up on income-oriented investments. The fund lagged the S&P in 2013 when interest rates rose and underperformed during the financial crisis. One reason for the latter was the inclusion of financial stocks, which used to be strong dividend payers. That sector is now underweight in the fund relative to the broader market. While the fund’s resources-related holdings may also be a drag on return in light of the recent sell-offs in oil and other commodities, VYM has a solid yield and good exposure to the healthcare and technology sectors.

The damage caused by the sell-off in the resource space, along with the recent bankruptcies in the coal industry, may not be over. The main catalyst appears to be an excess of supply in the face of an unanticipated slowdown in the Chinese economy, which may take several years to work off. VYM has a bit more exposure to the commodity space, mainly energy, than the broader market. As a result, investors should be aware of the performance risk moving forward, as opposed to blindly chasing the fund’s attractive yield. For long-term investors looking for income-generating investments, any further pullbacks in energy or the broader market could provide some very attractive entry points in VYM.