Because of these violent swings, investors waded into traditionally “defensive” sectors, including utilities, consumer staples, and healthcare.  Although these sectors historically produce lower earnings growth than other sectors, these defensive stocks are known for their history of low betas and for their ability to pay high (2-5 percent) dividend yields.   Beta is a statistic used to measure the volatility of a stock or portfolio compared to the market as a whole.  A stock with a beta of 1 has the same volatility as the S&P 500 Index.   The beta of these conservative sectors is usually half of this at 0.5.  By definition this means that historically these sectors increase 50 percent less than the market when the market is going up, but decrease 50 percent less when the market is going down[ii].  Without high systematic market risks, these stocks tend to weather financial downturns particularly well. 

S&P 500 Sector Performance, YTD (%)

[iii]

One example of a defensive sector is the utility industry.  The Dow Jones Utility Average – comprised of the stocks of 15 utility companies – declined by 3.43 percent during the treacherous third quarter compared to the Dow Jones Industrial Average declining by 12.10 percent[iv].  Even during economic downturns, people need water, heat, and electricity.  This is apparent in their historically stable cash flows.  In turn, utilities have been able to obtain easier financing, which has protected them from experiencing any liquidity issues even when the credit markets have seemingly dried up for other companies.  Furthermore, the companies in the DJ Utility Average have a current annual dividend yield of 3.89 percent  - higher than the DJIA’s dividend yield of 3.13 percent (as of November 15, 2011).  This allowed for shareholders to collect income on their holdings and use the proceeds to their discretion – a comforting notion in these rough markets.  As the chart below demonstrates, the dividend yield on electric utilities tend to track the yield on the 10-year US Treasury. 

[v]

Since both are considered safe havens, their prices typically rise in tandem which pushes their yields down.  With the spread between the two at its widest point since the 1970s, this may allow for investors to hold a conservative sector while still returning a higher yield than US Treasuries.

While volatility has spiked in recent months, it is still not close to the levels experienced during the weeks surrounding the collapse of Lehman Brothers.  The Chicago Board Options Exchange Volatility Index – commonly referred to as the “Fear Index” – measures the implied volatility of S&P 500 index options. The VIX spiked to an intraday high of 90 in October of 2008.  That implied a 25 percent change in stock prices in the next month[vi].  As of November 15, 2011, the VIX trades at slightly above 33.5, up sharply from its level in the spring of below 20.  During the financial crisis, low beta stocks outperformed the broader market as they are now.  From its peak in late 2007 of 1561 to its trough in March of 2009 of 666, the S&P 500 declined 57.34 percent (the S&P 500 is down 20 percent from its recent peak in April 2011).  During that time span, the Dow Jones Utility Average fell 39.41 percent, the consumer staples sector declined 34.18 percent, and the New York Stock Exchange Healthcare Index decreased by 42.76 percent[vii].  While those percent declines are staggering, on average the three sectors still outperformed the S&P 500 by 18.56 percent.  Although the broader market pulled these defensive sectors down with it, they still handily outperformed the benchmark index while still providing a healthy dividend stream.  In 2007, the total dividend paid on all US stocks was $288 billion.  From 2007-09, six of the nine major S&P industry sectors raised their dividends: consumer cyclicals, consumer staples, energy, health care, technology, and utilities.  At the end of 2009, the total dividends paid had fallen to $216 billion.  Yet, this decline was the result of essentially only the financial sector which cut its total payouts by $79 billion during that time span[viii] . Consequently, the utility, healthcare, and consumer staples sectors emerged from the “Great Recession” with the same stable business models but with even higher dividend payments.

With the stock markets in negative territory for the year, low beta stocks have been a place where many investors have parked their money.  As of November 15, 2011, the S&P Low Volatility Index, which consists of the 100 least volatile stocks in the S&P 500, is up 1.13 percent compared to a 2.98 percent decline in the S&P 500[ix].  As the previous evidence indicates low volatility stocks have historically tended to outperform the broader market during downturns.  Yet, can low volatile stocks outperform the benchmark indexes over the long run?  In a recent article in The Wall Street Journal, Ben Levisohn points to some surprising evidence:

“…the Low-Volatility Index has returned 80% during the past 10 years, compared with the S&P 500's 42.9%, assuming reinvested dividends. Go back 20 years, a period that includes most of the go-go 1990s, and the index has beaten the S&P 500 by about 180 percentage points, according to S&P, which set up the Low Volatility Index in April.”

[x]

Moreover, in a New York University study published in December 2010, it found that historically low-beta securities outperformed in 18 of 19 global equity markets, in Treasury markets, in corporate bonds, and in futures markets.[xi]  This data contradicts the long-held investor belief that the greater the risk, the greater the reward.  How can this be?  Several theories abound.  One theory is the fact that with less volatility those stocks fall less and therefore have less to make back.  By additional gains compounding on a larger base, these stocks grow more over time.  A second theory is because low volatile stocks are not the “sexy” stocks focused on by the media, hot money does not flow into low volatile stocks.  As a result they do not become overpriced and experience huge corrections.   Finally, a third theory hinges on the higher dividends paid out by low beta companies.  Through dividend reinvestments, a person’s assets can grow substantially by just allowing compounding to occur.  As the chart below demonstrates, the 30-year return (1979-2009) for the S&P 500 Index was substantially higher if all dividends were reinvested in the index than if none of the dividends were reinvested in the index.  The outperformance evinces the importance of dividends in an investment portfolio: reinvested quarterly dividends have historically accounted for almost 50 percent of total returns in stocks over the long term! 

[xii]

 

Dividend paying stocks are an alternative to government and investment grade bonds too.

With both the yield on the 10-yield US Treasury bond and core inflation hovering at around 2 percent (as of November 15, 2011), investors in

government bonds have the possibility of experiencing inflation-adjusted losses on their holdings.  If the economy continues to sputter, these fixed-income assets may allow owners to receive low single-digit returns.  Yet, if the economy begins to grow faster than the .7 percent pace during the first half of the year, interest rates may begin to creep up as well.  This could prove troublesome for bond holders, especially for owners of long-term (maturity in 10+ years) bonds.  Since bond prices move inversely to yields, a rise in interest rates will cause bond prices to decline.  In contrast, an investment in low-beta, high-dividend stocks do not expose holders to interest rate risk.  If the stock market increases, then the dividend yield of these stocks will decline, but investors will receive capital gains.  Moreover, whenever companies enjoy higher revenues, they usually increase their dividends which likely would cause their stocks to become more valuable.  Therefore, investors in dividend paying stocks can benefit both from the income generated from dividends and the potential for capital appreciation.

During periods of market upswings, low-beta, high dividend stocks can underperform the overall market.  In these times, speculators focus on riskier companies that might benefit from the rising tide.  In the eight years prior to March 2000, low-volatility stocks rose 126%, but the S&P 500 increased by 307%[xiii].  Throughout this time period internet stocks – many, such as Internet darlings pets.com and eToys, without any earnings – were bid up by speculators attempting to find the next Microsoft or IBM.  Then-Fed Chairman Alan Greenspan used the phrase “irrational exuberance” to describe the run up in the stock market[xiv].  He made that statement on December 5, 1996 – over 3 years before the dot-com bubble finally collapsed!  Consequently, in the short run riskier stocks can perform better than the overall market.  Low-volatility, high income stocks should be thought of as a viable strategy for investors focused on the long term.  In this way investors can take advantage of the steady cash flows by being able to accumulate a stream of dividend payments and not having to worry about a cyclical downturn imposing fatal losses on the companies.

For our complete database of articles please visit www.armstrongadvisory.com

 

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