5 Forecasts for Income Investors

Wall Street’s January ritual is to roll out “new” investment strategies. This year, fund manager Bill Gross has proclaimed the end of a 30-year bull market for bonds. So it’s no great surprise income advisors further down the food chain are pushing investors to adjust portfolios for higher interest rates.

To be sure, Mr. Gross’ fixed income offerings have been bleeding red ink in the face of rising US Treasury bond yields. But not all income investors are suffering.

The Alerian MLP Index, Dow Jones Utility Average (DJUA) and S&P Telecom Service Index, for example, all posted double-digit returns in 2013. So did the Capitalist Times Lifelong Income Portfolio, despite launching when the 10-year Treasury note yield was barely 2 percent.

Conrad’s Utility Investor Portfolios faced arguably even greater headwinds from rising interest rates when first published in August. Yet, the Aggressive Portfolio returned nearly 10 percent from that point, and the Conservative Portfolio was also well in the black.

In any given year, some dividend-paying stocks outperform, while others lag. Our biggest winners in 2013 were resource companies most spurned in 2012, such as Freeport McMoRan Copper & Gold (NYSE: FCX). Our laggards were generally conservative fare investors had previously favored.

That tendency of sector performance to reverse year to year—always contrary to prevailing market sentiment—is one big reason we’re OK holding leaders and laggards at the same time. More important, however, healthy and growing companies raise dividends over time, regardless of sector.

That in turn pushes share prices higher. Wealth builds year-in, year-out regardless of prevailing market winds.

Diversification and balance remain essential as we begin 2014. Here are five other forecasts to consider.

1. Dividend growth will drive returns, but only when companies beat expectations.

Dividend growth is the best antidote to the two transcendent dangers in income investing: Inflation and credit risk. A rising income stream built from a healthy and growing business holds its purchasing power over time, even if the value of money itself declines sharply.

Equally, there’s no better sign a dividend is safe than an increase. And as pointed out above, rising dividends drive stock prices higher over time.

That said, since this bull market began in March 2009, dividend growth investing has become extremely popular. High-profile stocks with records of strong growth now carry high expectations. And if a company boosts less than expected, it will sell off.

Once high-flying El Paso Energy Partners (NYSE: EPB) dropped nearly 20 percent within a few days in early December. The partnership announced a distribution growth target of 2 percent for 2014, well below a previously stated goal of 5 to 6 percent.

Distribution growth alone will not push share prices higher in 2014. Rather, companies have to surprise on the upside. And that’s become exceedingly difficult for high dividend growth favorites now showing up on many advisors’ buy lists.

High-quality, high-growth companies are still portfolio bedrock. In fact, despite a total return of 69.6 percent in 2013, Oil Tanking Partners (NSDQ: OILT)—a member of our freshly launched Energy and Income Advisor Master Limited Partnerships Portfolio—is still a good candidate for an upside surprise, as new storage projects further accelerate its distribution growth. Ability to surprise, however, is much greater with companies whose dividend growth has lagged, or which haven’t raised payouts for a while.

There’s always the risk that the weak earnings behind stalled dividends won’t strengthen, and payouts cut. But as we saw with Buckeye Partners’ (NYSE: BPL) 67 percent total return last year, there’s nothing like a return to dividend growth to spur a high yield stock. And if the US economy does continue to strengthen, there will many more Buckeyes in 2014.

2. It will be a tough year to make money in bonds.

I give no credence whatsoever to the oft-repeated prediction that we’ve entered a 30-year bear market for bonds. But there’s little doubt it will be difficult to make money in fixed income in 2014.

Ironically, US Treasury securities may be the safest corner of the bond market. Last year’s 72 percent rise in the 10-year yield was the biggest in decades. The 10-year yield is now four times that of equivalent Japanese government bonds, despite a 19 percent decline in the Yen/US dollar exchange rate in 2014.

That fact alone may lure global investors to Treasurys as the year goes on, particularly if inflation fails to clear the Federal Reserve’s 2 percent threshold for a tighter monetary policy. But it’s indisputable that Treasury paper is already pricing in a lot of “tapering” that has yet to occur, and may never.

In contrast, corporate bond yields are still near generation lows. The yield premium gap between high and low quality bonds is similarly narrow. And as I’ve pointed out in Capitalist Times, the Detroit bankruptcy and Puerto Rico’s weakening finances have dramatically increased credit risk in the municipal bond market.

Bonds still have a place in a diversified income portfolio. But the risk of rising corporate bond yields and/or municipal defaults argue for a strategy focused on short maturities and high credit quality. That was at least a breakeven approach last year. Shooting for yield, in contrast, was a loser and is likely to be once again in 2014.

3. Stocks priced in currencies outside the US dollar will rebound from a weak 2013.

Despite the incessant bickering in Washington, the US dollar reasserted itself as the world’s reserve currency last year. The buck rang up gains against almost every major rival except the euro, and rose 28.3 percent against gold as well.

The once-promising bitcoin has recently seen wild swings in value and now faces a crackdown in China and other Asian nations. And the Australian dollar/US dollar exchange rate has plunged nearly 20 percent, fully reversing an uptrend that began four years ago.

As a result, many high quality stocks on other shores are again cheap. And the rock-bottom expectations they carry won’t be hard to beat in 2014.

Many investors will be tempted to use the New Year to unload any stocks that lost ground in 2013. And non-US stocks could slip a bit further in the year’s early months, should the dollar gain from a surging US economy. Even the long-term outlook for the buck has brightened, thanks to emerging American energy independence.

What’s certain, however, is our US dollar can buy more of first-rate companies overseas than it’s been able to in quite a while. And history has shown us again and again that’s the time for patient investors to strike.

4. Short selling of high yielding stocks will remain elevated, as will potential short squeezes.

The fearful consensus’ conviction that dividend-paying stocks must follow the bond market is strong as ever. That alone has triggered unprecedented short volume in high yield stocks, where trading has historically been quite sleepy.

Short sellers “borrow” stock from their brokers, with the idea of buying it back later. They make money when stock prices fall and are responsible for paying dividends so long as they hold positions. Most also use a degree of leverage to magnify potential gains.

Short selling is particularly elevated in stocks now where dividends are considered at risk. More than a few have weakened, rewarding those who shorted early. But with so much piling on, the opportunity now is on the long side.

Investors who buy Linn Energy (NSDQ: LINE) now, for example, not only capture a 9 percent plus yield. But if the energy producer partnership’s unit price rises further—on an earnings or distribution boost, for example—they may enjoy the fruits of a short squeeze.

That’s what happens when a large volume of short sellers tries to close positions at the same time to cut losses. In Linn’s case, short volume is equal to nearly 5 percent of units in circulation, as well as 7.1 days of average trading volume.

That’s a lot of potential buy orders that could come on the market at the same time. The result would be a quantum leap in Linn’s share price in a very short period of time. Look for more such opportunities in 2014, particularly if the US economy surprises on the upside.

5. Returns from dividend paying stocks in 2014 will be as poorly correlated with interest rates as they’ve been the past 21 years.

Dividend-paying stocks behave like other stocks. They perform better when the economy is healthy, and suffer their worst losses when it craters as in 2008.

Interest rates can be an important factor, but only as they affect companies’ ability to grow. The straight up correlation between interest rates and performance of dividend paying stocks is non-existent.

Exhibit A: The 10-year Treasury note yield rose by more than 70 percent in both 2009 and 2013. Dividend paying stock averages across the board, however, finished both years on higher ground.

Exhibit B: Since 1992, dividend-paying stocks finished universally lower only in 2008. That was a year of falling interest rates, with the 10-year yield plunging more than 44 percent.

Maybe things really are different now. But barring that, the greatest risk to dividend-paying stocks in 2014 is actually a steep drop in interest rates. Inflation and rising interest rates were also the consensus worries in 2008, when global oil prices were pushing over $150 a barrel. But in the end, they took money out of the pockets of businesses and consumers, and crashed the economy.

That’s why I’m focused on my companies’ growth first and foremost as I execute my income investing strategy. Here’s to a super 2014!