Despite a number of uncertainties hovering over the market, US stocks have managed to deliver a positive return so far in the month--that is historically the worst month of the year for stocks.
With clear signs of the economy picking up momentum, the ‘taper’ now largely priced-in by the market and reduced chances of a military action in Syria, the outlook for stocks now appears to be brightening but debt ceiling debate and budget negations still remain potential threats.
As we approach the last quarter of this year, it may be a good time to look at your portfolio and realign it according to the changing investment landscape. (Read: 3 Ultra-cheap ETFs for Value Investors)
Time to Overweight Cyclical Sector ETFs
Many investors fear that rising rates will kill the stock market rally, but the fact is that the increase in rates reflects an improving economy and lower risk of deflation—which are positive for stocks. While economy is certainly not going to start growing at breakneck speed anytime in near future, the overall economic picture continues to brighten slowly.
Increase in interest rates are bad for stocks only when the central bank raises them to combat inflation, which is not going to be the case anytime in the near future. (Read: Senior Loan ETFs-The Best Bet for Rising Rates)
There are some sectors that will benefit more in the improving economic environment and this may be right time for investors to start repositioning their portfolio with higher allocation to some of the cyclical sectors like technology, industrials and energy that have a better earnings growth outlook for 2014, compared to the current year.
Technology sector has remained out of favor with investors due to several industry-specific issues and less-than supportive global macroeconomic environment. At current valuations, the sector looks attractive. Industrials also look poised to benefit from the strong revival in global manufacturing activity. (Read: Auto ETF in Focus as Car Sales Rebound)
Some of the top ranked ETFs from these sectors like iShares Industrials ETF (IYJ - ETF report) and Vanguard Information Technology ETF (VGT - ETF report) are worth considering.
Dividend Growth ETFs may outperform High Dividend ETFs
Dividend stocks and ETFs have experienced some headwinds in the face of taper talk, but investors need to remember that dividends have accounted for more than 40% of the total returns from the market over a long time horizon and thus they should be a part of any long-term investment portfolio.
Further dividend payments are expected to continue to increase in the coming months as most large US companies have huge cash piles on their balance sheet and are in a position to increase payouts to shareholders. (Read: 3 Excellent ETFs for Growing Dividends)
However, in my view, ETFs that hold stocks with a high dividend growth potential have much better outlook compared with ETFs that focus on high dividend yielding stocks. Most high-yield ETFs focus on sectors that are likely to underperform in the rising rates environment.
My top pick remains Vanguard Dividend Appreciation ETF (VIG - ETF report)—a Zacks Rank #1 (Strong Buy) ETF. It holds large high quality companies that have a record of increasing dividends for at least 10 years.
Current top holdings include Proctor& Gamble, PepsiCo, Wal-Mart and Chevron. With its current strong focus on cyclical sectors like consumer goods/services industrials and energy, this ETF is poised to do well if the economy in general and labor markets in particular continue to improve.
With an expense ratio of 0.10%, this is one of the cheapest funds in this space. The dividend yield at 2.2% is not remarkable, but this fund is better suited for investors who seek long-term capital appreciation along with income and not just high current yield.
Prepare for the Rise in Interest Rates
In anticipation of tapering, interest rates have moved up significantly, the 10-year Treasury note yield touched 3% recently—the highest since July 2011 and a sharp move from 1.6% seen earlier this year. While interest rates have come down slightly since then, the trend of rising rates still remains intact.
Going by the performance of Barclays U.S. Aggregate Index, bond market is on track to deliver its worst performance in the 37-year history of the index. Thus, you should get rid of all longer duration products in your portfolio, as they will be hurt the most in a rising interest rate environment.
Should investors still have some allocation to bonds? It depends on investors’ risk and return preferences and the investment horizon. Bonds do reduce portfolio volatility and provide diversification.
Investors could consider switching to ultra short duration products or products that provide protection against interest rate rise. Floating Rate ETFs like iShares Floating Rate Note Fund (FLOT - ETF report) and Senior Loan ETFs like PowerShares Senior Loan Portfolio (BKLN - ETF report) could be interesting options now.
These funds have returned 0.5% and 2.4% respectively this year while most bond ETFs have suffered losses. FLOT holds investment grade floating rate notes and yields 0.65% currently. Investors who are willing to assume a higher credit risk can consider BKLN, which carries a much higher yield of 4.99%.
Senior bank loans are issued by companies with below investment grade credit rating but they are safer than junk bonds as they are secured by collateral. However, since corporate leverage is at a very high level currently, the risk of defaults in this space may increase if the economy falls back into recession (which does not appear to be a likely scenario as of now).
Look for Gems among the Emerging Market Ruins
Emerging markets ETFs have seen steep declines this year mainly due to rising worries about the end of the era of cheap money. However, not emerging countries are in the same situation. In some cases, the current sell-off appears to be overdone and some of these markets offer excellent long-term investment opportunities at current valuations.
Emerging markets that depend on external capital flows to finance their wide current account deficits are most vulnerable to QE ‘tapering’. Further current crisis has also brought to the fore the structural problems that were already existing in some of these countries. (Read: Russia ETFs-Immune to Emerging Market Weakness)
Countries like India, Indonesia, Brazil, Turkey and South Africa are most likely to continue to suffer in the coming years. On the other hand countries like Mexico, South Korea and Poland that have sound macroeconomic fundamentals and lower dependence on hot money are likely to emerge as long-term winners. Consider investing in iShares Mexico ETF (EWW - ETF report) or iShares South Korea ETF (EWY - ETF report). Apart from fundamentals, economic pick-up in the US will also benefit both these funds.
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