There are a handful of conditions in the market right now that are likely to unwind themselves in the coming months and years. Some of them are already in the process of unwinding. Valuations are at generational highs. The long-term rate of earnings growth has also been well above trend. The tech sector has dominated the markets over the last decade while energy prices and equities have languished. And yet we are now experiencing a cyclical commodity shock, most notably in energy prices, and tech stocks have started giving ground.
Over the last year, and especially in recent months, I have tried to argue that the next decade will look different from the last. The great secular trends of recent years (for example, high tech and low energy) will be replaced by cyclical volatility that will obscure the formation of new secular trends. It will look in some ways like what has been happening since the beginning of the pandemic.
The rate of inflation is a good example of this. It can be at >7%, yet still people (including myself) believe that wherever the terminal rate ends up this year, we are still in a fundamentally low-growth, low-inflation era and this fire will choke itself out (with or without help from the Fed). This kind of disagreement about whether short-term developments are the beginning of new long-term trends or are just short-term aberrations is likely to recur throughout the 2020s.
In many ways, a transition towards more cyclical patterns is a more traditional market, back to a time when people invested in railroad stocks for the cash that would be returned to them. The problem is that with both valuations and inflation so high, now is perhaps one of the worst times to be buying into high-yield stocks.
In this article, I am going to look at the Vanguard High Dividend Yield ETF (VYM), contrasting it with some similar ETFs and recommend alternatives that are likely to preserve capital better.
The main challenge of high-yield equities is their cyclical vulnerability.
I take a first stab at illustrating that in Table 1. The data comes from the Fama-French data set and Robert Shiller.
The top half of the table shows the correlations between S&P Composite earnings growth on the one hand and dividend growth in the S&P Composite itself, in small-cap growth, neutral, and value indices, and in large-cap growth, neutral, and value indices, on the other. The correlations with dividend growth cycles are lagged 0, 8, and 12 months. I have bolded the large-cap value stocks, because they are of the most interest in this context. Although large-cap value stocks’ dividends are relatively immune to the vicissitudes of earnings growth concurrentlythey are especially sensitive in the following 8-12 month window. A sudden drop in market-wide earnings would therefore likely not be felt in dividends in the immediate aftermath of a crisis but would likely be strongly felt shortly thereafter.
The bottom half of the table suggests an even stronger effect in the relationship between these respective price indices and their dividend growth rates. This is perhaps more clearly illustrated in the following chart.
Cycles here are calculated as log changes over 36-month moving averages. Again, dividend follows price, especially in value stocks.
And, high yield dividend stocks do not have radically different price performance compared to the wider market.
The sum of Table 1 is that it is unlikely that high-dividend stock prices collapse because investors anticipate a fall in dividends. Rather, the collapse in dividends comes as a belated response to a market crisis. If there is a stock market crash, especially one experienced as a severe correction in long-term measures such as valuations or earnings growth rates, dividend investors are likely to suffer negative price returns and cuts to their expected dividends.
If the crash is temporary like it was in 2008-2009 and 2020 and almost every crash since the Depression, investors might be able to wait it out. If the collapse is more thorough, the declines in dividends could be considerable.
With valuations and growth rates being so high, the risk of a hard reversion suggests a need to emphasize preservation of capital. But the rate of inflation is itself eating away at that capital, and outside of the energy sector, there are few places where investors can turn to gain protection from the corrosive power of inflation.
But, this is the problem. Energy and high-dividend stocks are vulnerable to the vicissitudes of the cycle. As I explained in my energy piece last month, energy can rapidly reverse, and energy inflation itself can often be the catalyst.
We are likely approaching that cyclical peak. There are signs of this slowly cropping up, I think.
This is the ratio of VYM to the defensive staples index (XLP) alongside the 10-year yield and the copper/gold ratio, both cyclical indicators. In this instance, much as with the rate-hiking cycle in 2018, yields are rising while investors are squeezing into XLP. In 2018, it was ultimately the relative strength of XLP that proved to be “correct” about the direction of the cycle. This is likely to be the case this year, as well, although we can be sure it won’t play out the same way tick for tick.
Once the cycle does peak, we can expect defensives like gold, Treasuries, and staples to turn up on a relative basis as commodities and cyclicals, including high-dividend yield stocks sink.
VYM is composed of over 400 stocks, with the first 29 comprising 50% of the fund.
|VYM holdings as of 1/31/2022|
|% of funds||Cumulative % of funds|
|Johnson & Johnson(JNJ)||3.23%||3.2%||1|
|JPMorgan Chase & Co.(JPM.PK)||3.11%||6.3%||2|
|Home Depot Inc.(HD)||2.78%||9.1%||3|
|Procter & Gamble Co.(PG)||2.75%||11.9%||4|
|Bank of America Corp.(BAC.PK)||2.37%||14.2%||5|
|Exxon Mobil Corp.(XOM)||2.29%||16.5%||6|
|Coca-Cola Co. (KO)||1.69%||25.6%||11|
|Cisco Systems Inc.(CSCO)||1.67%||27.2%||12|
|Comcast Corp. Class A(CMCSA)||1.62%||30.5%||14|
|Verizon Communications Inc.(VZ)||1.57%||32.1%||15|
|Wells Fargo & Co.(WFC)||1.53%||33.6%||16|
|Eli Lilly & Co.(LLY)||1.48%||35.1%||17|
|Merck & Co. Inc.(MRK)||1.47%||36.6%||18|
|Texas Instruments Inc.(TXN)||1.18%||44.7%||24|
|Philip Morris International Inc.(PM)||1.14%||47.0%||26|
|NextEra Energy Inc.(NEE)||1.09%||48.1%||27|
|United Parcel Service Inc. Class B(UPS)||1.04%||49.1%||28|
|Bristol-Myers Squibb Co.(BMY)||1.03%||50.1%||29|
|CVS Health Corp.(CVS)||1.00%||51.1%||30|
That being the case, a sectoral breakdown might be more useful. Cyclical sectors take up a fairly large chunk.
This is the sectoral breakdown for VYM, according to Seeking Alpha.
The WisdomTree High Dividend Yield Fund (DHS) seems to have a higher emphasis on less cyclical components like health, nondurables, and utilities albeit with greater emphasis on energy.
The iShares Core High Dividend ETF (HDV) also appears to have a greater emphasis on defensive sectors.
This defensive orientations of HDV and DHS probably explain why it has, like XLP, outperformed VYM in recent weeks and is likely to continue to do so, if markets turn down.
VYM is likely to continue to provide greater exposure to the cycle than these other high-dividend yield funds, but this also exposes it to downside risk if and when the cycle turns. Shifting to more defensive funds or even to the XLP itself would reduce that risk, even if that will not entirely protect investors from losses in case of a crash or an extended period of low returns, both of which seem more likely than not. The most defensive position would be long-term Treasury ETFs like TLT or ZROZ.
With long-term bond yields rising late in the current cycle and the rising risk of a severe, long-lasting downturn, the relative risks of high-yield equity ETFs rise too. Every jump in energy prices and every leg up in bond yields brings us closer to the cyclical turn.