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Distortions in “Value”: Overpaying for Yield

Jeff Miller

In 2014, a global chase for yield is rippling across the U.S. stock market. For example, a strong appetite for anything with a decent yield has driven the performance of the Russell 1000 Value Index (RLV). In the RLV, utilities and REITs account for about 10% of the benchmark. This 10% has accounted for approximately 1.38% of the RLV’s 6.44% year-to-date return through July 31, as REITs have surged and investors have bid up utilities to levels that we believe will prove unsustainable going forward. Put another way, investors may be overpaying for yield in those two sectors at the expense of future total returns. We on the Calamos Value Team are unwilling to sacrifice future returns simply because a segment of the market is desperate for yield today.

As the yield on the 10-year U.S. Treasury bond hovers near 2.5%, and the yield on bank accounts and CDs is near zero, investors desiring current income face a choice: Either they can forgo current income for now, in the hope that rates will rise and they can invest in a year or two at those higher rates, or throw in the towel and buy.

Many have chosen to throw in the towel and buy, which to us seems to be a foolish long-term investment decision. It is our belief that over time, the decision to avoid these two overheated sectors will prove to be prudent. However, this view has created short-term headwinds for our opportunistic approach to value, which focuses on seeking companies that are temporarily out of favor but have strong operating businesses and cash flows, as well as managing risk over a full-market cycle.

What is driving investors to invest so aggressively in utilities and REITs? A lack of alternatives. Yields on government bonds in Europe are as low or lower than those here in the U.S. (For more on this, see the firm’s quarterly commentary “Navigating Complacency in a Growth Regime.” Bank accounts offer little respite. According to a recent article in The Wall Street Journal, the Chinese government has purchased more U.S. government bonds year-to-date in 2014 than in all of 2013, presumably to weaken its currency versus the U.S. dollar and therefore support China’s export-driven economy.*

Since inflation has remained very low here in the U.S. while the economy remains in a slow-growth mode, the Federal Reserve has maintained a very loose monetary policy, keeping its short-term rate at or near 0%. Couple this with a demographic phenomenon in the U.S. and much of the developed world, especially Japan, in which increasingly large amounts of the population are heading for or are already in retirement, and you have the perfect environment for elevating yield alternatives to unsustainable levels.

While we recognize these demographic and central bank forces and appreciate their ability to distort the market for income securities for a significant period, we continue to believe better long-term prospects can be found in other sectors of the market today. In particular, we find value in select financials that will benefit from higher rates, and in energy stocks that are benefiting from the U.S. energy boom and improving economy. Although a rate increase hasn’t yet occurred, investors shouldn’t think that it will be forestalled indefinitely. When rates rise, it could still come as a surprise. We want to invest ahead of the curve, looking for tomorrow’s opportunities among the real values in today’s market.

*Source: “China Plays a Big Role as U.S. Treasury Yields Fall,” The Wall Street Journal, July 16, 2014

Past performance is no guarantee of future results. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable. The views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations.

The Russell 1000 Value Index measures the performance of the U.S. large-cap value stock market. Indexes are unmanaged, do not entail fees or expenses and are not available for direct investment.

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