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Portfolio Update

Successful Income Investing in an Increasingly Passive World

By Roger S. Conrad, on Sep. 16, 2017

For an increasing number of stocks, simple “funds flow” has become a powerful driver of returns. When money comes into the stock market in general, prices rise in general–with little discretion. When it pulls out, prices fall in general–again with little discretion.

The primary reason is the rise of indexing and exchange traded funds (ETFs)—coupled with the advent of passive investing based on algorithms that control nearly 20 percent, and rising, of the total US stock market.

Ultra-low fees, broad diversification and the promise of not having to think about investing has driven hundreds of billions of dollars into ETFs sponsored by Vanguard, BlackRock (NYSE: BLK), State Street (NYSE: STT) and others that are managed by computer algorithms. Bank of America (NYSE: BAC) reports that passive Vanguard funds control at least 5 percent of 490 stocks in the S&P 500.

The more dollars investors pour into these funds, the more money flows into index-based ETFs—and, therefore, into the stocks inside of them. And with middle-class paychecks rising and unemployment falling, there’s a steady stream of saving that’s pushing these stocks higher.

The key question is what happens when the algorithm changes. Dividend-paying stocks, for example, have grown in favor since the Great Tech Wreck of the early 2000s, as more investors have sought income and defensive names.

The ironic result is many dividend-paying stocks that are household names are anything but defensive. For example, the Dow Jones Select Dividend Index, which underlies the popular iShares Select Dividend ETF (NSDQ: DVY) trades for more than 19.3 times trailing 12 months earnings.

The DVY’s ten largest holdings—comprising roughly 24 percent of the overall ETF—currently sell for nearly 24 times trailing 12 months earnings. That’s more than the S&P 500’s 21.4 times, a level that is its highest valuation since 2001.

High Valuations = Poor Defense

Those valuations suggest big DVY dividend-paying stocks wouldn’t offer much at all in the way of defense. After all, if there’s a selloff—and one is increasingly overdue—those stocks will be dumped in a big way.

Neither is a higher yield much of a value floor: The DVY ETF currently yields just 3.1 percent. That’s as low as it’s been since mid-2007, immediately prior to the 2007-09 bear market when the DVY lost nearly two-thirds of its value.

A repeat of the late 2008 selloff is probably the worst case for how low the DVY and its 100 stocks would fall in a full-on market correction.

But there’s also the risk of another flash crash. On August 24, 2015, for example, the DVY opened at $69.40 and closed at $71.79. Intraday, however, it traded as low as $48, a drop of more than 30 percent in literally minutes.

A massive wave of sells hit the market at the same time, temporarily overwhelming bids. Most investors in the DVY and its 100 leading dividend-paying stocks went through the day wholly unaware of the sudden catastrophe. Many investors who tried to protect bull market profits with stop/losses, however, were flushed out well below the levels they had set.

We’ve frequently cited Aug. 24 as a good example of why investors should be judicious about using hard stop losses, particularly for stocks of companies that have proven ability to weather bear markets and recession. It’s also a warning of what can happen to stocks that have become heavily passively owned, making them vulnerable to mass block trading when algorithms shift.

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