Wall Street's Best Minds

JPMorgan: Yield-Obsessed Investors Need to Think Differently

JPMorgan’s David Kelly has some advice for yield-chasing types: focus on total returns.

By David Kelly           

 
One of the most important lessons in investing and, for that matter, in life, is to recognize what is and isn’t in your control and to focus on the former.

Global financial markets are bogged down in stalemate today with not enough growth to push inflation or interest rates higher but not enough weakness to threaten recession. In the medium term, things look a little clearer. Provided the dollar and oil hold at current levels, global consumer spending should be strong enough to trigger a pickup in growth while U.S. corporate profits should rebound. Assuming that central banks react slowly to this change in the backdrop it should not inflict too much damage on the bond market and should boost stocks. This validates an overweight to equities over fixed income, even in a market that seems, for the moment, to be going nowhere. 
  
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David Kelly
 
 
However, while waiting for a rebound in economic growth and profits, investors should also consider their own behavior. In recent years, investors have scoured the world for higher-yielding securities in an attempt to generate a satisfactory income in an environment of falling interest rates.

A better approach would be to construct a diversified portfolio with a goal of achieving a satisfactory expected total return for an acceptable level of expected volatility. However, too many investors feel that it is somehow imprudent to ever sell principal, and so they have been lured into constructing a portfolio mainly with a bias towards yield rather than total return.

A few key points can show why this is foolish:

First, a balanced portfolio gives you far less in coupon payments and dividends than it used to.
For example, a $1,000,000 portfolio invested 50/50 in the S&P 500 stock index and the Barclays Aggregate bond index, would have generated $48,029 in pretax income in 1991, but only $24,056 in 2015. After the tax man, in taxable accounts, the decline would be even worse, from $33,140 in 1991 to just $16,285 last year. Living off income alone is getting more difficult except for the super rich.

Second, because investors have been searching for yield in an environment where yield is increasingly hard to find, they have been overpaying for it. This can be seen by looking valuations in different asset classes relative to history. The valuation measures we use are real yields (based off year-over-year core CPI inflation) for fixed income and real earnings yields (the inverse of the P/E ratio – core CPI in the case of equities. Mapping this relative to average dividend and coupon yields over the past 25 years shows that while large-cap growth stocks (with traditionally low dividend yields) are selling near normal valuations, investment grade bonds are roughly two standard deviations more expensive than they have been on average over the last 25 years. 

Third, higher-yielding, higher-quality securities are particularly exposed to any backup in interest rates, which must be considered a key risk in an extended business cycle where a pickup in inflation could cause a change in central bank policy from its currently uber-dovish stance. Statistical evidence from the last 25 years suggests that while a one percentage point increase in 10-year Treasury yields could actually result in an increase in stock prices, it may reduce high-quality corporate bond prices by -6.5%.

Finally, for taxable accounts, it is far more tax efficient to realize capital gains on appreciating stock than to clip coupons on fixed income. The highest marginal federal tax on interest income is now 43.4% compared to 23.8% on both dividends and capital gains. Moreover, precisely because investors can sell principal, the actual tax paid on realized stock sales should be far less than on dividends received.

In a sluggish economy with now more highly valued assets, investors should not expect to receive the same returns that have prevailed over the last 5 years or the last 50.

However, investors can still achieve better risk-adjusted returns by adhering to some basic investment principles. While the best known principles are diversification and not trying to time the markets, another is to see the logic in investing for total return rather than yield.

After years in which yield-hungry investors and ultra easy central banks have distorted markets by driving down yields, it is more important than ever to recognize that not selling principal is a lousy principle.


Kelly is chief global strategist with J.P. Morgan Funds, a unit of JPMorgan Chase.

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