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IQ Trends: "It's About Time"

02/23/2018 5:00 am EST

Focus: DIVIDEND

Kelley Wright

Managing Editor, Investment Quality Trends

The markets aren’t broken, they’re simply starting to work again. What has been transpiring over recent weeks has a name — it’s called normal, and it’s about time, asserts Kelley Wright, dividend expert and editor of Investment Quality Trends.

Understand that a properly functioning market doesn’t go up, or down, unimpeded, forever. Markets are comprised of human beings with nervous systems and emotions who think, feel and react differently. As such, market participants have competing objectives, which creates conflicts, that are expressed as volatility.

The market needs competition. The market needs conflict. The market needs volatility. If all market participants were on the same page at the same time there would be no competition, or conflict, or volatility, and therefore no risk. Without risk there would be no returns. Historically, the ability to understand and manage risk is what separated success from failure.

During the era of Quantitative Easing (QE) much of the inherent risk in the stock market was artificially stymied. To be fair, the policy may have avoided a global depression in 2009, so I don’t want to re-litigate the efficacy of the policy’s initial intent. Equally fair, however, is the argument that the policy remained in place too long, and wreaked havoc on the stock and bond markets.

In terms of stock and bond prices, the policy was successful. In other areas of the economy not so much. There was obviously deflation in bond yields. For many years there was deflation in unemployment. Real corporate earnings, not the phony bologna financial engineering farces that were passed off as earnings, were few and far between. Commodities were ravaged, with crude oil and the entire energy complex being the most visible victims.

The collateral damage wasn’t limited to just the above however. Fixed-income investors, who were not comfortable with the inherent risk in the stock market, were forced into stocks in search of yield and returns, which drove valuations to the sky and dividend yields to historical lows. Volatility, which has historically acted as a brake on investor sentiment, virtually disappeared.

With the Fed virtually guaranteeing that declines in the stock market would be met with another infusion of liquidity, investors became emboldened to buy stocks with impunity. This eventually resulted in a level of investor hubris and market narcissism  that became delighted with itself and the relentless parade of new highs in the major market averages.

The bond market, which dwarfs the stock market, and is definitely the smarter of the two, sat on their hands and essentially abandoned their role as the monetary sheriff that maintained order. In the bond market’s defense, it is difficult to fight the Fed, albeit not impossible.

Mercifully it appears the worm has turned, and the bond market has awoken from its slumber. Yields on the 2-Year and 10-Year Treasuries have moved up sharply and appear to be prepared to break long-term trendlines that will confirm what was telegraphed in July of 2016 — the bull market in bonds and interest rates that began in 1982 is over.

To be sure there will be some counter-trend rallies where interest rates dip, but the low yield on bonds is in. These counter-trend rallies will suck some into interest-rate sensitive securities that will enjoy a short run, but those gains will be short-lived.

The major point I wish to make in this missive is that this time isn’t different, and there are and always will be some objective truths in the market. Supply and demand matters. Liquidity, or the lack thereof, matters. The yield curve and the return on guaranteed, “risk-free” securities matter.

Quality and values in stocks matter. The ability to recognize when value is, or isn’t, present in the broad market matters. Good performance  in a bull market doesn’t make you a genius, it simply means you were in when the trend was your friend.

The correction will end and the uptrend will resume. Volatility is back, however, and the ride won’t be as smooth as it has been. This is a welcome thing to the value investor, as volatility will create pullbacks that provide opportunities to acquire shares of high-quality stocks at Undervalued yields and prices.

The ability to pick stocks, as opposed to baskets of stocks, will be important once again. Not just any stocks mind you, but value stocks with long histories of excellence and performance.

For example, here are 8 stocks that meet our investment criteria and rank as our top current recommendations based on being undervalued stocks with strong earnings quality metrics and a history of outstanding long-term annual dividend growth: Franklin Resources (BEN), Weyco Group (WEYS), CVS Health (CVS), Coca-Cola (KO), Hormel Foods (HRL), Walt Disney (DIS), Omnicom Group (OMC) and IBM (IBM).

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