For some time, I (along with many others) have been a proponent of using stocks for income, given record low interest rates. Stocks such as Merck, which a few months ago yielded 5% and had a current-year price/earnings ratio of 9, represented excellent value. But Merck, and others like it, have risen significantly. Merck now sells for nearly 12 times earnings, and its dividend yield has fallen to 3.9%. This still may look attractive compared to the 1.5% yield on a 10-year U.S. Treasury note, but I am cautious after the rise in many stocks.
Two equity sectors that have been popular among investors who seek yield are utilities and real estate investment trusts (REITs). I consider them both quite unattractive at current levels. Though utility yields still are relatively high when compared to government notes, their valuations are poor at mid teens price/earnings multiples (and poor free cash flow generation and high debt levels). Leading REITs now yield 3% or less, and typically a portion of the dividend yield on a REIT is a return of capital, so the effective yield is less. I know it was a historic buying opportunity, but I remember when a decade ago REITs commonly yielded 7% and were selling at discounts to their real estate asset values. I would avoid both groups now.
It is still extraordinary for the major U.S. stock indexes to have dividend yields that are higher than the interest rate on a 10-year government note. That surely is a plus for stocks. I am concerned, however, about the risk of earnings disappointments in coming months.
While U.S. Government securities repeatedly have held up well (even rising in price) during periods of market stress, I would avoid them and instead favor corporate bonds. I have a significant stake in high-yield bonds, despite their popularity. This is despite their equity-like performance in periods of market stress, such as in 2008, when most high-yield bond funds fell more than 20%. That is a risk I'm willing to take.
In the meantime, I suggest holding significant cash while researching stocks and compiling a buy list and setting target prices.
S & P 500: 1355