Posted by on May 28, 2013 in Blog, Columns, Featured |

By Jason Zweig | May 25, 2013  12:01 a.m. ET

That was close.

The U.S. stock market escaped the selloff in the Japanese market—at least for now. When the Nikkei Stock Average dropped 7.3% this Thursday, the Standard & Poor’s 500-stock index fell by as much as 1.1% during the day, only to finish down a hair.

 But the plunge in Japan, triggered partly by fears that interest rates might rise, is a wake-up call for U.S. investors. It is worth peering inside your portfolio to evaluate which assets could be most vulnerable once the Federal Reserve finally stops keeping interest rates unnaturally low.

Many companies whose stocks have recently been wildly popular for their income and safety—and that have gorged on cheap debt—could suddenly turn into pariahs.

“Highly leveraged companies [those with high levels of debt] have done extremely well in the past three years,” says Harindra de Silva, a portfolio manager at Analytic Investors, an investment firm in Los Angeles that manages $8 billion. “But they have the potential to really hurt you going forward.”

A rotation already might be under way; suddenly, the “safety trade” is faltering. Real-estate investment trusts, utility stocks, high-dividend companies and “low-volatility” stocks (which move up and down less sharply than the market as a whole) all have been performing spectacularly well—until this month, when they started to fade.

Many such companies, which investors have been buying for their perceived safety and income, have borrowed heavily.

The S&P 500, up 12.7% in the first four months, has added another 3.5% in May. Stocks with high dividends, as measured by the SPDR S&P Dividend exchange-traded fund, crushed the market with a 16.4% return through April; in May, however, they fell behind, adding less than 3%. Low-volatility stocks, up 15% and more until this month, stayed flat in May. REITs, with a 15.4% gain through April, have lost 1.2% so far this month. And utilities, which returned 19.9% in the first four months, have fallen 5.6% in May.

“The conservative stocks had done so well and gotten so expensive,” Mr. de Silva says, “that it’s almost like people have started saying, ‘Well, if everything’s going to go up, I might as well buy the cheaper, riskier stocks now.'”

Consider that at the end of April, utilities were trading at 22.9 times their earnings over the past year and low-volatility stocks at 24.9 times, versus 21.2 times for the S&P 500. High-dividend payers were trading at 17.2 times their projected earnings over the next year, with the S&P at 15.1 times next year’s estimates.

History shows that whatever is stretched tends to tear when interest rates rise.

On Feb. 4, 1994, the Fed jacked up rates in the first of what would turn out to be five increases that year. Then, as now, the backdrop was a period in which “money the Fed has been so generously creating has been flowing into securities…and may have been creating a securities market bubble,” as The Wall Street Journal wrote the day after the first rise in rates.

That day, the Dow Jones Industrial Average tanked 2.4%—”partly,” wrote the Journal, “because of uncertainty about how far the Fed will go.”

The biggest fear of investors then was that the Fed would tank the markets, which still were recovering from the recession of 1990-91. That didn’t quite happen; the U.S. stock market overall earned 1.3% for the full year in 1994.

But the damage was widespread, hitting supposedly safe and risky assets alike. For the full year, utility stocks lost 15.3%; municipal bonds, 5.2%; emerging markets, 8.7%; intermediate-term Treasurys, 5.7%; the U.S. bond market as a whole, 2.9%; gold, 2.2%. REITs eked out a gain of 0.8%; without their generous dividend yield of roughly 7%, they would have lost 6.4%. (The average yield on REITs today is a bit over 3%.)

There was no index of low-volatility stocks back in 1994. Mr. de Silva’s research shows, however, that in periods of rising interest rates, these stocks have tended to underperform the market as a whole by an average of about 0.8 percentage point annually.

This past week’s tumble in Japan confirms the lessons of 1994. Just the thought of what will happen when a central bank tightens the faucet of easy money can spook many investors.

REITs, dividend-paying companies, utilities and low-volatility stocks all have a place in a portfolio. But they aren’t worth paying a premium price for—and, as safe as they have seemed until recently, they won’t offer blanket protection once the fear of rising rates becomes reality.

The many investors who have been overloading their portfolios with this kind of safety may soon be sorry.



Source: The Wall Street Journal