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The Fear Trade Is Still Alive

We nearly did a spit take on Wednesday when we saw the Federal Reserve’s latest long-run projection for its federal funds rate: 3.0%.

That’s down from 3.3% in March and 3.5% in December, the latter of which was already embarrassingly low before the two downward revisions. In more normal times, 3.0% would mark the end of a rate-cutting cycle, as it did in 1993, not the end of a rate-hiking cycle.

This benchmark short-term rate is one of the central bank’s primary policymaking tools, since so much of the credit that fuels economic growth, or at least inflates financial assets, is pegged to it.

In some ways, we like to think of the federal funds rate as the cost of money. Right now, the cost of money is still dirt cheap. Shockingly, the Fed’s own projections indicate that the cost of money will remain dirt cheap by historical standards even at the end of its rate-hiking cycle.

This is the sort of cycle that could upend the conventional wisdom that rising rates are bad for dividend stocks, such as utilities.

Thanks to long-term studies of stock performance, we already know that the conventional wisdom in this area is largely bunk—dividend stocks can still come out ahead of non-dividend payers during a rising-rate environment, especially if shareholders are reinvesting their dividends.

Nevertheless, we still see financial journalists dutifully parrot this conventional wisdom, even though the real story is more complicated (it always is).

Certainly, the Fed’s long-run projection underscores its recent dovishness, which suggests rates will be lower for longer, and that any interest-rate normalization will be dragged out.

Right now, for instance, a majority of traders don’t expect to see another rate hike through at least February 2017, according to futures data aggregated by Bloomberg.

Of course, trader sentiment tends to bounce around with overall market sentiment, and a dissenting opinion from a Fed policymaker could easily change this picture, but it still offers a rough guide to the smart money’s expectations about the direction of interest rates.

Beyond that, the picture is further clouded at the moment by anxiety over what the so-called Brexit might portend. The U.K. is voting next week on whether to exit the E.U., and if it does then that would imply a further crack-up of the Continent’s currency union. As such, central bankers and other policymakers are inclined to make more soothing noises than usual at the moment.

Consequently, the fear trade is very much alive. During periods of uncertainty, investors tend to pile into safe-havens such as U.S. government bonds, which pushes up prices while lowering yields. The yield on the benchmark 10-year Treasury note, currently at 1.61%, hit a low of 1.52% intraday this week, its lowest level since 2012, which means that year’s all-time low is in sight.

The Happy Dilemma Revisited

Meanwhile, utility stocks, one of the other major safe havens, have posted astonishing returns on a year-to-date basis. At the outset of the year, we wondered whether market conditions could make this another year of the utility.

When we wrote that article, we were thinking gains of 10% to 15% would be nice. Instead, the Dow Jones Utilities Average is now up nearly 19% this year.

Much as we love utilities, that performance is not based on the fundamentals of that benchmark’s underlying stocks.

As we’ve frequently written in recent months, utility-sector gains have created a happy dilemma for income investors: We’re enjoying the rise in share prices, but we’d like the opportunity to add more high-quality stocks to our portfolios at reasonable prices.

Unfortunately, most utilities command premium valuations at present, so there are few to no bargains, especially among fully regulated names.

The other dilemma is we know that eventually there will be a reversion to the mean. While recent macroeconomic events have favored utilities, that won’t always be the case. The Fed could turn more hawkish or the markets could turn so bearish that even safe havens are pulled down with it.

And that raises the question of whether to cash in on recent gains, or at least take partial profits, with an eye toward picking up utility stocks at a more reasonable price once the inevitable correction comes.

The problem for income investors is that if you don’t own dividend stocks, you’re not getting paid. And we have no idea how long the proceeds from such a sale might be idle–it could be just a month or two, or it could be half a year.

This decision ultimately becomes a math problem for each investor, depending on their average cost basis, the magnitude of the correction they’re looking for (and whether they’re likely to see it), what sort of tax hit they might take on a sale, and how long they can afford to let the proceeds idle, among other considerations.

On the other hand, some income investors treat utilities as almost akin to bonds. They’re quietly collecting their dividends or even more quietly compounding their wealth through reinvestment, and they’re almost indifferent to short-term fluctuations in valuations.

Everyone’s situation and tolerance is different. But it might help to have some concrete numbers in mind. The Dow Jones Utilities Average’s current valuation based on the price-to-earnings ratio (P/E) is 19.4, while its average over the trailing 10-year period is 15.2. If the index were to drop to its average valuation, then that would require a decline of roughly 21.6% from current levels.

That seems unlikely in this environment. Last year, however, there were three Fed-fueled selloffs among utility stocks, with an average decline of 11%. That seems like a more likely scenario, at this point.

If we do see such a decline, then that would put utilities firmly in formal correction territory, though they still wouldn’t be bargains. Even so, that’s better than buying at current levels–or chasing utility stocks ever higher.


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