Are Stocks Overvalued?

Are Stocks Overvalued?

Settle for Safety or Reach for Yield?

A Safe Income Stock

Last week, Fed Chairwoman Janet Yellen caused a stir by suggesting that the stock market is overvalued, saying equity valuations are “quite high.” To Fed watchers, that suggests that an interest rate increase may be coming sooner rather than later.

Even more interesting to me was Yellen’s comment that stock valuations “are not so high when you compare the returns on equities to the returns on safe assets like bonds, which are also very low.”

In other words, stocks are overvalued, but there’s a good reason for it: if you want to make a decent return on your investments today, the stock market is the place to be.
And yet, despite the laughably low yields on fixed income—what Yellen was referring to when she noted that their returns are “very low”—there’s still very high demand for “safe” assets today. The demand is so high that bonds are even more overvalued than stocks, according to the Chairwoman.

Anyone who’s tried to secure a decent return on a “safe” investment in the last five years already knew this to be true, but hearing it from the Fed Chairwoman’s lips was newsworthy.

Yellen’s comments contributed to a massive selloff in bonds, in both Europe and the U.S. The sharp drop in demand caused a spike in yields, sending the yield on the U.S. 10 year treasury to 2.3% briefly, while some long-term European government debt was offering the highest yields in five years.

But bargain hunters stepped in within days, and fixed income is hardly less overvalued today than it was last week. The big picture explanation is the investing public’s hunger for yield in the face of paltry supply.
Consider this chart of the 10-year treasury yield since 1965:

“Safe” investments just don’t yield what they used to, but investors still want security. And they also want yield, which is responsible for the “reach-for-yield type of behavior” that Yellen noted as a risk in her comments Wednesday. (Specifically, she pointed to compression in spreads on high yield debt as evidence of investors taking on additional risks today to secure slightly higher yields.)


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So what’s a yield-hungry, risk-averse investor to do today?
Well, as Yellen herself noted, on a risk-reward basis, the equity market is a better place to be today than fixed income. Stocks don’t have the same principal guarantees as fixed income, but buying shares of high-quality, long-lived companies with predictable income streams going forward is the next best thing.

In Cabot Dividend Investor, my premium advisory, we call them “Safe Income” investments and have a tier of our portfolio dedicated to these long-term holdings. Here’s our criteria for selecting these stocks:

The Safe Income tier of our portfolio holds long-term positions in high-quality stocks and other investments that generate steady income with minimal volatility and low risk. These positions are appropriate for all investors, but are meant to be held for the long term, primarily for income—don’t buy these thinking you’ll double your money in a year.
For example, the first holding in my Safe Income tier (alphabetically) is Aflac (AFL), an insurer that does much of its business in Japan. Aflac has faced sales challenges over the past year, and the yen’s decline against the dollar has made year-over-year earnings comparisons tricky. But the insurer earns consistent, passive income from premiums and investments, and passes that cash along to investors in the form of quarterly dividends.

Currently, Aflac yields 2.5%. The stock is also resilient, trading in a tight sideways range during the market’s last six weeks of turmoil. Long-term, I expect Aflac to reward investors with steady returns and regular dividend increases.
If Aflac sounds like the kind of low-maintenance, buy-and-hold type of investment you want in your portfolio, consider trying out Cabot Dividend Investor today to see all 10 of my current Safe Income tier recommendations. 


Chloe Lutts Jensen
Chief Analyst of Cabot Dividend Investor


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