Monetary policy helped create a roaring year for stock indices in U.S. equity markets in 2019. Led by the U.S. Federal Reserve (Fed), dovish global central bank guidance and eventual rate easing sent stocks to their largest gains since 2013. As a result, the Fed is likely to hold in 2020, with communications indicating the “insurance” cuts are over.
Modest global growth likely will continue. It should be supported by the resilience of the U.S. consumer, despite continued weakness in global manufacturing. Earnings should take center stage as markets look beyond the Fed for the next growth catalyst. Multiple expansion accounted for 92% of the market’s 2019 appreciation, as valuations raced ahead of profits.
But there is a risk of complacency. The Global Economic Policy Uncertainty Index has reached an all-time high, but implied equity volatility has not followed suit. We expect volatility to rise.
U.S. equity markets are at their top-heaviest since 1999. Apple gained more in equity value in 2019 than any other company in history, its stock surging 86%. This sent Apple’s market cap to $1.3 trillion, a gain of $556 billion. That valuation is bigger than all but the top four S&P 500 companies – and roughly equal to the entire Spanish or Italian stock markets.
The top five stocks (Apple, Microsoft, Amazon, Facebook and Alphabet) make up about 17% of the S&P 500 Index. This exceeds tech bubble concentration (13.66% among General Electric, Exxon, Pfizer, Cisco and Citigroup in December 1999). An earning miss or adverse news from one or more of these companies could have outsize effects on the total market.
Passive ascendancy may be contributing to this mega-company dominance. Over the past 10 years, the U.S. stocks that outperformed the broad market were mostly mega caps. Only 32% of stocks in the S&P 500 index managed to beat their index; almost half did in the previous decade.
Up from just 20% 10 years ago, passive investing represents about half of U.S. fund assets. The money pumped into index funds benefits larger companies disproportionately, because their benchmarks are mostly weighted to market cap. A decade ago, about 15 cents of every dollar put into SPDR or Vanguard 500 index went into technology stocks. Today’s share is about 25 cents.
On the political front, U.S. Presidential impeachment proceedings will likely have limited impact on financial markets, but they will continue to fan the flames of partisan polarization. This could boost the election prospects of more extreme candidates, leading to even greater uncertainty.
Iran and North Korea could flare up again, their situations being stable yet unpredictable.
Amidst the domestic and global uncertainty, we advise investors to take positions in stocks likely to achieve high earnings and high dividends. Investors also should be prepared for a style rotation.
Markets led by high momentum stocks (1999, 2007, 2013) are often followed by markets led by high dividend stocks (2000, 2008, 2014), as investors overshoot expectations on high growth companies and return to more consistent dividend payers. If as expected they maintain low rates, the Fed’s support should make equity dividends an appealing alterative to fixed income.
Among sector plays, utilities, real estate and consumer stables have more than doubled the yield of the S&P 500. Investors can avoid yield traps by buying companies with strong fundamentals – high earnings, lower payout ratios and lower price/earnings – alongside high dividends.
Sustainable dividend paying stocks with attractive valuations and high yields include:
- Verizon (NYSE: VZ): The largest, highest quality wireless provider’s 5G opportunity is starting to crystallize. Defensive communications play with incremental upside. 4.12% dividend yield (Communications Services sector 1.22%, S&P 500 1.79%). 11.49x trailing P/E ratio, trading at a 51% discount to the sector. 62% dividend payout ratio.
- General Mills (NYSE: GIS): Favorable near-term earnings growth, strong pet business (Blue Buffalo acquisition) and potential upside to earnings estimates over the two years. 3.69% dividend yield (Consumer Staples sector 2.68%). 15.54x trailing P/E ratio, trading at a 30% discount to the sector. 60% dividend payout ratio.
All is not roses, however, and investors should not simply look for high dividend yields. Take auto companies like Ford (NYSE: F) and General Motors (NYSE: GM), with healthy dividend yields of 6.49% and 4.35%, respectively. We expect near term headwinds for the consumer discretionary sector, with fourth quarter earnings forecast down 14% from the year before. Ford and GM are two of the biggest contributors to this decline. These companies – and Amazon (NASDAQ: AMZN) – may have unsustainable dividend yields.
2019 has been another stellar year for equities, and bookending a stellar decade for investors in market cap passive indices. Richness in the market resulting from this expansion coupled with looming uncertainty on economic and geopolitical issues increase the likelihood of volatility and rotation in equity markets as we move into 2020. Prudent investors may seek to reposition their equity allocations, away from top-heavy market cap weighted indices and focusing on high earnings and dividend yield stocks which have typically fared better in volatile markets.
QS Investors is a subsidiary of Legg Mason. Mr. LaBella's opinions are not meant to be viewed as investment advice or a solicitation for investment. Securities are mentioned or informational purposes only and not to be considered a recommendation to purchase or sell any security.
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