The growing risks in the hunt for yield

Falling bond and term deposit yields will have investors mulling a switch into higher-yielding shares. But the risk of capital loss from buying stocks is rising.

The RBA’s rate cut and the possibility of more to come have created an expectation that investors will continue to buy stocks. Many retirees will be considering softening the impact of falling bond and term deposit yields by switching into higher-yielding shares.

Yet the risk of capital loss from buying stocks is rising. While it seems likely that current central bank policy will push share valuations inexorably higher in pursuit of yield, it may pay to be open to the contrarian view that this is not a certainty. Investors may begin to baulk at the risks involved. For chart followers, this possibility has been given some immediacy as the ASX 200 index approaches a potential resistance level.

The dividend yield and risk trade off

Australian 10-year bond yields are below 2.5 per cent. While banks are trumpeting cuts in the mortgage rate, term deposit rates will also be coming down. So superficially, stocks like Commonwealth Bank and Telstra with FY15 dividend yields around 4.7 per cent before franking, and 6.7 per cent after, look pretty tempting.

Over the past couple of years it’s been my view that valuations for good quality, Australian ‘yield stocks’ weren't too excessive, even on a long-term basis. It seemed to me that many market followers might have been surprised by how little stocks pulled back once interest rates started to increase. This is especially the case as moves to normalise interest rates come when the outlook for the economy and earnings growth is improving.

However, when circumstances change, traders and investors need to change their thinking. It seems likely that, from these levels, any further drop in yields on stocks like CBA and Telstra will be all about the low interest rate regime and not sustainable if rates rise. It’s not likely they would sustain a yield of say 4.25 per cent with bond yields back to 4 per cent. In this scenario, the risk of future capital loss looks high, especially if low rates don’t last too long.

To be attracted to dividend yields from here on, investors will have to believe that:

  • Low rates are here for the medium term, allowing plenty of time for higher dividends and earnings growth to offset the risk of capital losses OR
  • They can bail out of yield stocks before other investors get wind of higher rates, minimising the extent to which capital losses wipe out the extra income from dividend yields

From a short-term trader's point of view, this logic means that it's worth being open to the possibility that investors might actually be too risk averse to keep pushing share prices up much higher despite the driving force of lower rates.

Index chart resistance

Current chart resistance might be a useful guide to investor thinking in coming days. If the index starts to baulk here, we could see at least a minor correction indicating ongoing caution and keeping us within the gently expanding pattern defined by the blue lines on the chart below. For Fibonacci traders, the fact that an ABCD pattern coincides with the trend line resistance adds to its potential significance. At around this level CD = AB x 1.618 (a key Fibonacci ratio). 

Technical and fundamental analysis by Ric Spooner, Chief Market Analyst at CMC Markets @ricspooner_CMC

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