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Dividend Investor
Safe Income and Dividend Growth

Cabot Dividend Investor 917

In today’s issue, we’re adding a unique play on financial markets to the Dividend Growth tier. I also have a write-up on interest rates—the driving force behind many of this month’s sector rotations—at the end of the issue.

Cabot Dividend Investor 917

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Another Round of Rotation

The stock market has lost some momentum since our last update. The major indexes stalled out late last week, then posted big losses Monday, with large-cap tech stocks leading the decline.

On the flip side, money has been rotating into stocks and sectors that have underperformed so far this year. Energy and financial stocks were the two best-performing sectors over the past week. That’s benefitted some of our holdings, especially in the High Yield tier.

Elsewhere, interest rates held their gains, contributing to further slides in utilities and real estate stocks.

[highlight_box]What To Do Now: I’m not making any rating changes today. I am adding one stock to the Dividend Growth tier, profiled below. That leaves us with six positions rated Buy, plus our bond ladder. Eight more positions are rated Hold, though High Yield holdings General Motors (GM) and Pembina Pipeline (PBA) are both gaining momentum. [/highlight_box]

Featured Buy

CME Group (CME)

CME Group owns and operates exchanges where options, futures and derivatives are traded. The company’s namesake is the Chicago Mercantile Exchange, or “the Merc.” The world’s largest derivative exchange, the CME offers contracts based on interest rates, stocks, currencies, commodity prices and more.

In 2007, the CME merged with the Chicago Board of Trade, or CBOT, the primary options exchange. One year later, CME consolidated its control of commodity futures trading by acquiring the New York Mercantile and Commodity Exchanges (NYMEX and COMEX).

And in 2010, CME Group bought the Dow Jones Indexes, acquiring control of the Dow Industrials.

In other words, a large percentage of the financial activity you read about on any given day—from options trades to changes in interest rate expectations to moves in oil price futures—occurs on one of CME’s 24-hour exchanges.

Commodity futures were originally designed to allow commodity producers like farmers and miners to hedge against price changes by transferring unwanted price risk to speculators. The producer could lock in a price for their future production, and the speculator got a chance to bet on the price of a commodity without owning it.

Today, futures contracts are still widely used for hedging in many industries. For example, most airlines use hedges to limit their exposure to changes in fuel prices.

But futures—and similar derivative products—have sprung up in lots of new areas as well. Many, like interest rate derivatives, still have practical uses. (Companies whose costs rise when rates rise can hedge some of that risk using interest rate futures, for example.) However, derivatives are now also widely used purely as financial instruments, mostly by institutional investors.

This steady expansion of the derivatives market has fueled steady growth at CME Group. Revenues have increased in each of the last five years, by an average of 4% per year. Net income has also increased every year, by an average of 11% per year.

And CME continues to introduce new types of derivatives regularly. At the end of 2016, the company announced that is it working on a blockchain-based gold trading platform.

Analysts expect CME Group’s EPS to grow by another 6% this year, and by 11% next year. Revenues are expected to grow by 3% and 6%. The company has beaten estimates in each of the last four quarters.

The Dividend
CME Group pays regular quarterly dividends of 66 cents, for a current yield of just about 2.0%. However, the company also distributes excess cash as a special dividend at the end of each year. Last year’s special dividend of $3.25 more than doubled the stock’s annual yield.

CME has paid these special dividends in each of the last five years. The company has also increased its regular dividend for six years in a row. At the same time, the stock’s payout ratio has declined, from a high of 66% in 2012 to 51% today. That helps earn CME a solid Dividend Safety Rating of 7.6. The company’s annual dividend increases of around 6% and high-single-digit earnings growth expectations earn CME a Dividend Growth Rating of 6.0.

The Stock
CME trades at a current P/E of 27 and a forward P/E of 25. The stock built a long base during 2015 and the first half of 2016 before finally breaking out past the 100 level in July of last year. CME gradually rose 30% over the next 14 months, finding support at its 40-week moving average on multiple occasions. Earlier this month, CME bounced off its 50-day moving average to break out to new 52-week highs. The stock is now trading at its highest level since 2007, when it peaked around 140 shortly before the financial crisis.

I’ll add CME to the Dividend Growth Tier of our portfolio at the stock’s average price on Monday, October 2. Investors interested in steady dividend growth, capital gains and special dividends can do the same.

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CME Group (CME)
Price: 133
52-week range: 98.95-134.63
Market cap: $45.62 billion
P/E: 27
Current yield: 2.0%
Annual dividend: $2.64
Most recent dividend: $0.66
Dividend Safety rating: 7.6
Dividend Growth rating: 6.0
cdi917-cme.png
Dividends since: 2003
Consecutive years of increases:
6
Qualified dividends?
Yes
Payment Schedule: Quarterly
Next ex-dividend date:
December 7, 2017 est.

Portfolio at a Glance

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Closing Prices on September 26, 2017

Portfolio Updates

High Yield Tier

CDIpyramidHigh

The investments in our High Yield tier have been chosen for their high current payouts. These ?investments will often be riskier or have less capital appreciation potential than those in our other ?two tiers, but they’re appropriate for investors who want to generate maximum income from their? portfolios right now.

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HOLD – General Motors (GM 40 – yield 3.8%) – GM hit another new 52-week high Monday. The stock is benefiting from this week’s rotation into stocks that have lagged so far this year. The stock is up 4% since our last update. While momentum is certainly strong, the rally looks a little precarious. Nothing has changed at GM, and analyst estimates haven’t budged. Shorter-term investors could do a little profit-taking here, but in our portfolio, I’ll just keep GM on Hold.

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HOLD – Pembina Pipeline (PBA 35 – yield 4.1%) – I wrote last week that if PBA could break out past its 52-week highs from late July, it would be a bullish signal. That’s exactly what happened Monday, as a rally in energy stocks propelled PBA above 35 for the first time in over two years. I’ll keep PBA on Hold while we see if the breakout sticks. Pembina is a Canadian pipeline company that pays reliable monthly dividends denominated in Canadian dollars.

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BUY – Welltower (HCN 72 – yield 4.8%) – The likelihood of a December rate hike has continued to rise over the past week, after Janet Yellen said Wednesday that the Fed expects normal inflationary pressures to reappear soon. REITs, which are typically negatively correlated to interest rates, have declined about 2% since our last update, and we’ll likely see a lot more volatility in REITs ahead of the Fed’s December meeting. HCN pulled back sharply at the end of last week, but found support at its 200-day moving average Monday. With the stock near the bottom of its trading range, I’ll keep it cautiously on Buy for volatility-tolerant high yield investors.

Dividend Growth Tier

CDIpyramidDiv

To be chosen for the Dividend Growth tier, investments must have a strong history of dividend increases and indicate both good potential for and high prioritization of continued dividend growth.

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HOLD – BB&T Corp (BBT 45 – yield 2.9%) – BB&T Corp is a regional bank offering a broad range of financial services in the South, the mid-Atlantic region, Texas and some of the Mid-West. Financials have been on a tear since interest rates bottomed early this month. BBT has been underperforming the sector slightly, but looks healthier after finding support around 44 for a second time. Dividend growth investors can hold for long-term gains and the steady dividend.

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BUY – Broadridge Financial Solutions (BR 81 – yield 1.6%) – Broadridge is a tech company that provides information and services to financial companies. BR re-tested the 80 level last week, and broke through it to the upside on Friday. BR looks very healthy, and Dividend Growth investors who don’t own it can buy a little here.

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HOLD – Carnival (CCL 65 – yield 2.1%) – We sold half our CCL shares at last Wednesday’s average price of 65.31, after the stock’s second gap down on high volume. Over the next three days, CCL drifted lower, falling below support at 65. However, the stock rebounded to 66 yesterday, after Carnival reported third quarter earnings that beat expectations. Adjusted EPS rose 19% to $2.29, beating estimates by nine cents. Revenues rose 8% year-over-year and beat estimates by $130 million. More importantly, management said that the recent hurricanes will impact fourth quarter earnings by $0.10 to $0.12 per share, less than feared. Most of Carnival’s major ports in the Caribbean and Mexico are fully operational, and bookings and prices for next year remain well ahead of last year. Management even raised the low end of their 2017 guidance, to $3.64 from $3.60 per share (the high end remains $3.70 per share). We’ll continue to Hold the rest of our Carnival shares.

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BUY – Cummins (CMI 168 – yield 2.6%) – Cummins makes heavy-duty engines for trucks, ships, mining equipment and more. CMI has been trading sideways since our last update. The stock is a stone’s throw from all-time highs, but faces short-term resistance at 170. If the positive momentum in industrials continues, we could see the stock surpass that level and hit new highs within the week. Dividend Growth investors who don’t own it yet can buy a little here.

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SOLD – Prudential Financial (PRU 106 – yield 2.8%) – We Sold PRU earlier this month, for a 23% total return. The stock is looking healthier now, thanks to the bounce in financials, and will likely return to its trading range between 100 and 115. But we’re happy to focus on stocks with stronger momentum.

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BUY – Wynn Resorts (WYNN 145 – yield 1.4%) – WYNN’s recent surge faded this week, possibly influenced by Monday’s selloff in year-to-date winners. But the stock is only a hair off 52-week highs, and its uptrend looks intact. Dividend Growth investors can use this pullback to Buy a little. Wynn owns two casino resorts in Macau and two in Las Vegas, and is building the first major casino in the Boston area.

Safe Income Tier

CDIpyramidSafe

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.

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BUY – 3M (MMM 211 – yield 2.2%) – 3M is a diversified provider of technology and products ranging from Post-it Notes to electronic stethoscopes to the coating sprayed on road signs to make them more reflective. The company has paid dividends for 100 years. MMM is trading near 52-week highs, but still faces upside resistance around 215. I’ll keep the stock tentatively on Buy for Safe Income and Dividend Growth investors.

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HOLD – Consolidated Edison (ED 82 – yield 3.4%) – ConEd is a New York-area utility. The stock has been heading south since interest rates bottomed early this month, which is not surprising. The stock’s long-term uptrend remains intact, but investors can anticipate more interest-rate related volatility ahead of the Fed’s December meeting. I’ll consider putting the utility back on buy for long-term income investors if the stock bottoms around 80 again (where it would meet its 40-week moving average).

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HOLD – Ecolab (ECL 130 – yield 1.1%) – Ecolab provides cleaning, efficiency and sustainability technology and services to a wide variety of industries. A Dividend Aristocrat, the stock is a solid long-term hold for income investors. However, it’s lacking short-term momentum, and is currently rated Hold.

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BUY – Guggenheim BulletShares 2018 High Yield Corporate Bond ETF (BSJI 25 – yield 4.0%)
BUY – Guggenheim BulletShares 2019 Corporate Bond ETF (BSCJ 21 – yield 1.8%)
BUY – Guggenheim BulletShares 2020 High Yield Corporate Bond ETF (BSJK 25 – yield 4.8%)
BUY – Guggenheim BulletShares 2021 Corporate Bond ETF (BSCL 21 – yield 2.3%)
These four funds make up our bond ladder, which is a conservative strategy for generating income. Each fund matures at the end of the year in its name, at which point Guggenheim disburses the net asset value of the ETF back to investors. We recently sold our 2017 fund, because the yield declines as the end of the year approaches and the fund’s bond holdings mature. So now our ladder is made up of high yield ETFs maturing in 2018 and 2020, and investment-grade ETFs maturing in 2019 and 2021. All the funds pay dividends monthly, at the start of the month.

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HOLD – PowerShares Preferred Portfolio (PGX 15 – yield 5.5%) – PGX is a Hold for investors who want reliable monthly income. The preferred share ETF doesn’t have capital appreciation potential, but it trades in a low-volatility range between 14 and 16 and pays monthly dividends of about seven cents per share. I generally put the ETF back on Buy when it trades below 15, but if you’re looking to add a low-risk position to the income portion of your portfolio, you could buy a little here.

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HOLD – Xcel Energy (XEL 48 – yield 3.0%) – Xcel Energy is a Minnesota-based utility with large wind power holdings. The stock fell this month due to the rise in interest rate expectations. But the stock’s day-to-day moves don’t matter much to us: we’re in it for the long-haul. I’d consider putting XEL back on Buy on a pullback to the stock’s 200-day, currently around 45. Long-term safe income investors who already own the stock can continue to Hold.

Dividend Calendar

Ex-Dividend Dates are in RED and italics. Dividend Payments Dates are in GREEN. See the Guide to Cabot Dividend Investor for an explanation of how dates are determined and what estimated dates mean.

DivCal 2017.xlsx

Sue Hourihan

DivCal 2017.xlsx

Sue Hourihan

Interest Rates into Year-End

Interest rate expectations shifted quickly this month, as traders tried to anticipate how changes in geopolitics, economic data and financial markets would affect Fed policy. You may have noticed the ripple effects of these moves in your own portfolio, impacting utility stocks and other income investments. You should anticipate more unpredictability over the coming months, as the Fed’s December meeting approaches. Odds that the Fed will hike rates at that meeting are currently over 70% (up from 30% earlier this month), but are likely to remain volatile. Here are a few data points to watch if you want to know what to expect.

Inflation
Inflation is the most important data point the Fed considers when setting interest rates. Inflation has been running persistently below the Fed’s 2% target for years, but the Fed has hiked rates four times since late 2015 anyway.

Inflation got close to the Fed’s 2% target at the start of the year, hitting 1.9% in January, but then slowed down. Lower inflation readings over the next eight months contributed to a steady slide in interest rates. In the second week of September, the yield on the 10-year treasury hit 2.052%, its lowest level since the U.S. presidential election (see chart).

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However, inflation started to perk up in August, and is expected to accelerate in September due to rising oil prices. Hurricane Harvey forced many Gulf Coast refineries to close, taking about a quarter of U.S. refinery capacity offline and sending oil prices above $50 per barrel for the first time since May.

Core inflation numbers for August will be released on Friday, and analysts are expecting a 0.2% increase month-over-month, which is equivalent to annual inflation of 1.4%. If inflation falls short of expectations, even with the effect of the hurricanes, interest rates may head south once more.

Employment
After keeping inflation in check, the Fed’s most important job is maximizing employment (these two goals are often referred to as the Fed’s “dual mandate.”) The unemployment rate ticked up slightly in August to 4.4%, but is still close to the Fed’s goal.

The recent hurricanes may temporarily increase unemployment claims in the affected areas, but the Fed expects that to be offset by a rebuilding-related boost in economic activity.

The Bureau of Labor Statistics will report the September unemployment rate and any change in average wages on Friday, October 6.

Fed Balance Sheet Run-Off
The Fed will start shrinking its balance sheet next month. The Fed currently holds $4.5 trillion in fixed income securities, purchased during and after the recession to create liquidity and further depress interest rates. When securities mature, the central bank reinvests the proceeds. Starting next month, the Fed will allow $10 billion in maturing securities to “run off” the balance sheet instead. The monthly run off will be gradually increased each quarter until it reaches $50 billion per month next year, gradually shrinking the Fed’s fixed income holdings and putting gentle upward pressure on interest rates.

The “Third Mandate”
Some Fed watchers think the Fed has a “third mandate” that will push them to hike rates again in December, despite low inflation and moderate economic growth. Interest rates directly affect financial market behavior, and the Fed may want to raise rates again to curb speculation caused by easy money policies. While not technically part of the Fed’s mandate, the data backs up the Fed’s (hypothetical) concerns. The Goldman Sachs U.S. Financial Conditions Index measures how tight or loose financial conditions are—is it hard and expensive or easy and cheap to obtain money? And despite the Fed’s last four rate hikes, the index is now at its lowest level since 2014, indicating that financial conditions remain very loose. That could be part of the reason the Fed seems so intent on raising rates, despite little evidence that the economy is overheating.

Other Factors
Lastly, numerous other factors can push interest rates and rate hike expectations around day-to-day. Early this month, North Korean missile tests contributed to rates’ decline by increasing demand for treasuries. Stock markets sold off briefly after North Korea fired missiles over Japan and tested a hydrogen bomb in early September, triggering a scramble for safe assets. Increased demand for U.S. treasuries contributed to a decline in their yields.

Another contributor to rates’ slide earlier this month was the resignation of Fed Chair Stanley Fischer on September 6 (though he’ll remain on the board until mid-October). Fischer is a defender of traditional economic models that suggest inflation accelerates as the unemployment rate drops. With him out, the Fed may lean more dovish.

And this week, the White House pre-announced a tax cut plan that could substantially increase the U.S. deficit and the supply of treasuries. That would create downward pressure on yields, although the market’s reaction so far suggests that the plan has a slim chance of becoming law.

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