For cold-blooded markets, the big political event of the week was not so much the lawless mob storming the US Capitol building.
Individual investors were shocked and repulsed by the events in Washington spurred by the rages of Donald Trump in the final days of his tumultuous presidency. But after a brief wobble on Wednesday, US and global equities resumed their recent trend of setting all-time highs.
Investors appeared to be looking ahead to the transfer of power that culminates in the inauguration of Joe Biden as US president this month — a succession belatedly acknowledged by Mr Trump.
“Markets, rightly in our view, see the US government as ultimately a stable enough set of institutions even if things occasionally go pear-shaped,” said Nicholas Colas, co-founder of independent research house DataTrek.
Of greater significance to markets than the Capitol invasion was this week’s shift in the US Senate following run-off elections in Georgia. These will leave the chamber evenly divided between the two parties with the deciding vote on budget matters in the hands of the vice president-elect, Kamala Harris.
This will give the Democratic party more leeway to push through a spending boost to support the economy while the rolling out of vaccines gathers pace in the coming months. Disappointing US jobs data for December probably reinforces the push for more fiscal support. In turn, this renews the momentum behind trends within equity and bond markets that have been unfolding in recent months.
These include rising long-term interest rates and inflation expectations that reflect hopes of an accelerating economy later this year. Both US 10-year interest rates and inflation expectations increased sharply this week and are driving a repositioning in equity markets. The benchmark 10-year Treasury yield crossed 1 per cent for the first time since March last year.
Falling 10-year interest rates boost the valuation of companies that are growing quickly as their future cash flows are discounted at a lower rate. Reverse that trend and highly valued tech and growth stocks that have surged in the past two years look less appealing.
In turn, stronger economic prospects along with higher inflation make life easier for less jazzy companies to generate better earnings. Tech has duly begun the year lagging behind energy, materials, banks, small and mid-caps.
“Low interest rates have helped push up equity valuations and now that tailwind is no longer blowing so hard,” said Jack Ablin, chief investment officer at Cresset Capital, a family office wealth manager.
The arrival of January tends to see investors assess whether recent laggards are worthy of owning versus areas of the market that have done very well. One approach is known as buying the “dogs of the Dow” — investing in the 10 companies that have the highest dividend yields in the Dow Jones Industrial Average at the start of January. The higher yields represent a lower valuation for the companies.
From 2001 until the start of 2019, the dogs strategy recorded a solid record. Bank of America estimates they delivered an average annual total return of 9.5 per cent in the period, eclipsing a 7.3 per cent gain for the S&P 500, including the reinvestment of dividends.
But after lagging the broad market during 2019, the dogs were left looking badly flea-bitten in 2020 with a total return of minus 8 per cent compared with the S&P 500’s gain of 18.4 per cent, once the reinvestment of dividends are included. From the lows of last March, the dogs of last year are up 45 per cent versus the broader market’s climb of almost 70 per cent.
This year’s dogs — Walgreens, Chevron, Dow, IBM, 3M, Cisco, Coca-Cola, Amgen, Merck and Verizon — kicked off the year with an average dividend yield of 4.1 per cent, according to Bank of America.
For the dogs to show some bark and reverse their recent underperformance, a strong rebound in corporate profits is needed.
The dogs have done better in the past in the rallies from the nadir of recessions. From 2003 to 2007, BofA estimates the dogs delivered a return of 13.74 per cent with dividends reinvested compared with 13.15 per cent for the broader S&P 500. Likewise, from 2010 through to 2014, they offered returns of 18.25 per cent versus 15.85 per cent for the US stock market benchmark.
“After 2001 and 2009 there was a major shift in economic momentum that brought contrarian plays to life,” said James Paulsen, chief investment strategist at The Leuthold Group. He added that investors could find good dividend payouts from global companies that would benefit from an international economic recovery in 2021.
Mr Colas at DataTrek added that among the current dogs, the likes of Chevron, Dow and 3M would have a “lot of leverage to an economic recovery”.
However, he said the fast-growing technology sector was seeing a boost to earnings from trends arising from the pandemic such as working from home. This will make it harder for the dogs to outperform. For contrarians though, this presents opportunities.
“Wherever you find your earnings surprise is what leads your share portfolio,” said Mr Colas.
michael.mackenzie@ft.com