Memo to Bernanke: It’s showtime on tapering

The Dividend Growth portfolio had a rough summer, giving up a fair bit of its outperformance from the first four months of the year. As of August 31, the portfolio was up 16.2% year to date vs. 16.15% for the S&P 500 Index. But over the past 90 days, in which the S&P 500 Index has been flat, the portfolio was down a little over 4%.

Yet our Sizemore Investment Letter portfolio has had a great summer. Since late June, the portfolio has rallied by about 9%, roughly double the S&P 500’s return for the period.

Why the reversal of fortune? It’s all about Europe.

In the Sizemore Investment Letter portfolio, I am overweight in my investments in Europe—and I was two quarters too early. After trailing their American counterparts for all of 2013, European stocks took the lead in the third quarter.  Since bottoming in late June, European stocks—as measured by the Vanguard FTSE Europe ETF (VGK)—have had returns double those of the S&P 500 Index.

What gives? After months of dismal economic news, the European economy is improving. Furthermore, while the Fed has indicated that tapering is a matter of “when” and not “if,” the European Central Bank had gone to great lengths to convince the investing public that it would not be following suit. ECB President Mario Draghi said in July that rates would be at current or even lower levels for an “extended period.”

My bullish arguments for Europe remain intact. European stocks are cheaper than their American rivals and tend to pay better dividends. They are also broadly hated by the investing public and very under-owned. If you believe—as I do—that the Eurozone with muddle through, having the occasional mini-crisis but avoiding a major blow-up, then overweighting Europe makes sense.

What about American income stocks? I noted last month that income sectors, and REITs in particular, had stopped reacting to rising bond yields. That is a good sign that we might have seen a bottom in the dividend-paying income-stocks sell-off that started in May.

We probably won’t see a major rally in dividend stocks until we get clarity from the Fed about what tapering might look like and when it will start. I expect tapering—whenever it starts—to be modest, and I expect bond yields to drift lower. At time of writing, the 10-year Treasury yields 2.85%. I expect to see something more along the lines of 2.3%-2.5% by the year end.

Meanwhile, I continue to see a lot of value in high-quality, triple-net retail REITs and in select master-limited partnerships and dividend-paying stocks. An ideal investment for the Dividend Growth portfolio is one that pays 3%-4% in dividends or 5%-7% in the case of REITs and MLPs.

Importantly, I need to have a reasonable belief that the company will raise that payout in the years ahead. While I expect bond yields to fall, I’m fully aware that I could be wrong.  And if I am wrong—and yields continue to march higher—I expect a high-dividend-growth portfolio to outperform a pure high-dividend portfolio.

The investments discussed are held in client accounts as of August 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.  Past performance does not guarantee future results.

Photo credit: Eric Landstrom

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