Is the Quest for Yield Distorting US Equity Markets?

« Low global bond yields are pressuring US Treasury yields, while inflation outlooks are muted and the Fed appears on hold with rate hikes. All of these points favor high dividend yields »… Makes sense although this is massively pushing investors into the most expensive territories of equity markets !

From Morgan Stanley equity quant team:

« With the US 10-year yield below 1.4%, and still looking enticing relative to other developed market yields, it is not surprising that many investors are looking for dividend yield in US equities. We observed several manifestations of high yield focus: (1) a lack of attention to valuation, as forward P/E and other valuation ratios underperformed; (2) the strongest performance since at least 1976 of the dividend yield factor relative to the total
yield factor (this latter quantity includes buybacks, which are not a cash payment); and (3) the strongest performance since 2006 of the dividend payout ratio. In addition, low beta, quality and defensive stocks are intertwined with high yield, and all cohorts outperformed in June.

Macro conditions appear favorable for a continuation of strong high yield performance in the coming months. Low global bond yields are pressuring US Treasury yields, while inflation outlooks are muted and the Fed appears on hold with rate hikes. All of these points favor high dividend yields. At the same time, periods of risk aversion could arise from multiple sources, ranging from Italian Banks to Chinese growth. Risk aversion would also favor defensive, and low beta stocks and therefore high yield stocks.

There are risks to high yield stocks beyond interest rate increases: investors may begin to care about elevated valuations, and dividend cuts could ensue (especially for high payout stocks) if economic growth slows. In light of these risks, but cognizant of the good environment for high yield, we have included a screen of stocks that rank in the top two quartiles of Diva, our high yield specific alpha model. This tool penalizes stocks that have excessively high payout ratios and considers valuation metrics (though these are not weighed too heavily). This list has a diverse set of sectors represented.

Where Do Stock and Industry Opportunities « Remain » Post-Brexit?

Since the British referendum to leave on June 23, equity markets have recovered most of their immediate losses, as have credit markets. Interest rates have continued to decline, however, and oil prices remain weak. Given the high macro volatility, we looked at the divergence between actual returns of stocks and industries from June 24 to July 5, and longrun expected returns over this period. The long run returns are based on macro models that account for equity market, yield curve, credit spread, currency and commodity exposures. We combine the coefficients of these models with macro factor returns since Brexit.

In the absence of fundamental news since June 23, the differences between actual and long-run expected returns should mean revert in the coming weeks and months. That is, if a stock or industry has exceeded its anticipated performance given the market, crude oil, interest rate, etc moves, this positive deviation is regarded as noise, and is expected to close.

Similarly, equities that have underperformed their model-projected returns are candidates for near-term outperformance.

Post-Brexit, financials have underperformed even accounting for the decline in interest rates. A number of cyclical industries have also lagged their long-run model-based returns. On the other side, utilities and defensive industries have outperformed after taking into account the benefits they expect to receive from declining rates. At the stock level, companies from the staples, health care and discretionary sectors have had the largest outperformance relative to expectations. Conversely, financials, materials and technology stocks have thus far been the biggest post-Brexit laggards. »

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