October 4, 2023

Rates Rise, Stocks Fall

The market selloff is getting worse. The S&P 500 is now down more than 8% from the high and within bad breath distance of 10% correction territory. The culprit is interest rates.

The market had pulled back just a little bit from the end of July high until the middle of September. But things deteriorated after the Fed meeting. The S&P has fallen 6% since the Fed uttered that hawkish “higher for longer” phrase about interest rates.

The benchmark 10-year Treasury rate has been rising since and just hit yet another 16-year high of 4.8%.

The hope had been that high interest rates would be temporary. It was thought that, with inflation falling sharply, interest rates would fall as well. Markets were even pricing in Fed rate cuts later this year or early next. It is finally sinking in that those things will not happen, and the market is repricing.

A soft landing and still strong economy has its drawbacks. It spurs inflation and higher interest rates. The rates are a problem for stocks as rising costs devalue growth projections and that hurts technology stocks. It’s also a problem for companies with high debt levels such as utility stocks. Also, higher competing rates on fixed income investments make dividends less attractive.

Perhaps a slowing economy will stop the recent ascent of interest rates and the market will rally. But the market is not in a good situation right now as rates remain in a sharp uptrend.

The current interest rate spike has prompted a downgrade in our portfolio’s fixed income investments. USB Depository Shares (USB-PS) and Vanguard Long-Term Corp. Bd. Index Fund (VCLT) are being downgraded from “BUY” to “HOLD”. Rising interest rates cause price declines and the rating will be reduced until interest rates at least stabilize.

Invesco Preferred ETF (PGX) shares are being SOLD from the portfolio. This preferred stock ETF has similar interest rate risk and also has another risk: It has mostly preferred stocks of banks. Higher interest rates caused the regional bank failures earlier in the year and still higher rates could reignite the crisis. The two risks make a bad risk/return tradeoff right now.

While this selloff may get worse, at some point it will create buying opportunities and the diversified portfolio can weather the storm in good relative shape.

Recent Activity

October 4
SELL Invesco Preferred ETF (PGX)
USB Depository Shares (USB-PS) - Rating change “BUY” to “HOLD”
Vanguard Long-Term Corp. Bd. Index Fund (VCLT) - Rating change “BUY” to “HOLD”

High Yield Tier

Enterprise Product Partners (EPD – yield 7.3%) – This midstream energy partnership is holding up remarkably well in this tough market. In the last month the S&P 500 is down 5% and EPD is up about 2% and continues to hover around the 52-week high. It has also returned 19% YTD after a strong performance in last year’s bear market. Earnings are resilient in just about any economy and the sky-high distribution yield is very well covered with cash flow. (This security generates a K-1 form at tax time). BUY

ONEOK Inc. (OKE – yield 6.0%) – This historically more volatile midstream energy company stock is having a rough time in the current market and is down 7% over the past week. The problem is interest rates. Investors become concerned that the company has less earnings growth potential because of the higher cost of borrowing for acquisitions and expansions. It doesn’t have as many recent acquisitions or cash on hand as EPD. But the dividend is safe and business is still very resilient and the company raised earnings guidance for the rest of the year. HOLD

Realty Income (O – yield 6.2%) – This rock solid, legendary income REIT has not lived up to its reputation of late. O just hit a brand-new low that is the lowest price for the REIT since the pandemic bear market more than three years ago. Defensive stocks have been poor performers all year. But operational performance has been sound as earnings were solid with a stellar 99% occupancy rate for its properties and an additional $3.1 billion invested in the quarter in 710 properties. There is a new round of selling in these already beleaguered defensive dividend stocks because of the recent spike in interest rates. BUY

The Williams Companies, Inc. (WMB – yield 5.3%) – The crummy market is even getting to WMB a little bit. The midstream energy company stock moved sharply higher in the summer until leveling off around the middle of August. It’s still in the higher range after the summer surge but it too is showing some signs of weakness in this market. Perhaps renewed strength in the more commodity price-sensitive energy stocks can reignite further upside from here. Earnings were solid and recent expansion and acquisition activity bodes well for growth in 2023 and 2024 beyond what was expected. BUY

Dividend Growth Tier

AbbVie (ABBV – yield 4.0%) – Health care stocks have held up relatively well in the recent market tumult. ABBV is getting through this challenging year in decent shape. It has returned -5% YTD. But it has been a lot better over the last two months when it has been up 10%. It is struggling with shrinking revenues because of the loss of U.S. patent protection for its blockbuster Humira drug. But the company has the pipeline to overcome in the not-too-distant future. The recent solid earnings report emboldens the notion that AbbVie will turn the corner sooner than expected. BUY

Broadcom Inc. (AVGO – yield 2.2%) – This AI juggernaut has cooled off since the big surge in the spring and early summer. It’s down over 11% from the high. That is to be expected considering the technology sector is getting whacked lately. But AVGO has still returned 52% YTD. Artificial intelligence gives the company a huge growth catalyst going forward, and it isn’t going away. If AVGO falls below 800 per share it might be time to repurchase the half position that was sold early in the summer. HOLD

Brookfield Infrastructure Partners (BIP – yield 5.2%) – The tough times for safe stocks continue. Despite strong operational performance in a period of shrinking earnings for most companies, BIP continues to make new 52-week lows as investors fear interest rates will limit growth potential. The price hasn’t been this low since the pandemic bear market more than three years ago. But earnings have been solid and growing with remarkably resilient revenues ahead of a likely slowing economy. It’s a historically strong market performer selling at multiyear lows with a safe 5.2% yield. (This security generates a K-1 form at tax time). BUY

Digital Realty Trust, Inc. (DLR – yield 4.0%) – This data center REIT had been solid and defied the challenging market until September. It’s pulled back over 9% since the end of August and spoiled the uptrend that began in May. DLR has been a victim of the overall market and the selloff in the technology sector spurred by rising rates and the hawkish Fed. But the operational performance of the company has been solid. The market may not have priced in the additional growth catalyst Digital is likely to get from significantly increasing artificial intelligence spending. BUY

Eli Lilly and Company (LLY – yield 0.8%) – Even LLY is cooling off in this market. It’s pulled back over 14% from the new high made early last month. It has still returned 48% YTD and remains in the higher echelons of the recent range, but it is showing some vulnerability here. Investors are unlikely to stay sour on LLY because the company has two potential mega-blockbuster drugs up for FDA approval this year as well as stellar earnings growth for the next several years. If it falls further, the portfolio may buy back the half position we sold last spring. HOLD

Hess Corporation (HES – yield 1.1%) – The energy exploration and production company stock hit a new 52-week high in the middle of September but has since fallen about 10%. Oil prices stopped going higher and have been stuck right around $90 per barrel of West Texas Intermediate (WTI) around the same time the market turned ugly. HES is highly levered to energy prices and there may be a sense among investors that prices have peaked. But a pause in oil prices after a big spike is normal and the pause may be temporary as global supply is still strained amid strong demand. BUY

Intel Corporation (INTC – yield 1.4%) – After hitting a new 52-week high in mid-September, INTC abruptly pulled back 15%. INTC typically pulls back after a spike. But there was also some bad news. At a company event management indicated that it would take longer to turn around revenue and earnings. Plus, the Fed’s hawkish tone on interest rates also hurts the technology sector. But the bleeding stopped and INTC moved higher last week and has since remained strong while the sector and the market continue to fall. BUY

Qualcomm Inc. (QCOM – yield 2.9%) – The chipmaker stock continues to struggle through this year. It has returned just 3% YTD while the technology sector is up over 30% over the same period. The sector is being driven by stocks with exposure to AI that are benefiting right now. It’s a little soon for Qualcomm. The company is highly dependent on smartphones. And sales have been falling as the 5G cycle comes to an end and the global economy is sputtering. But smartphone sales may have bottomed out and QCOM could benefit mightily and move fast when things turn around. BUY

Tractor Supply Company (TSCO – yield 2.0%) – The farm and ranch company stock has been getting slapped around as investors are worried about the continued resiliency of the consumer. But Tractor’s rural consumers have already been weak for a while and the company has been successfully compensating with its vast array of staple products. Last quarter, the company delivered 8.5% EPS while average S&P 500 earnings were down. TSCO should be solid in just about any environment with a low beta and a highly resilient product base. BUY

UnitedHealth Group Inc. (UNH – yield 1.4%) – The recently underperforming health care stalwart has been one of the few bright spots over the last few weeks. It’s actually up 6.5% in the last three weeks while the market has been cratering. Operational performance is stellar and UNH is a superstar that has blown away the returns of the overall market over the past five- and 10-year periods. The stock may be coming alive again as investors are gaining a new appreciation for a dependable health care stock in this market. BUY

Visa Inc. (V – yield 0.7%) – V is down about 6.9% since the market turned sour in mid-September. But it levelled off before the market. V has shown superior resiliency in similar markets. There may be more downside if the market deteriorates from here but I expect the stock to recoup most of the recent losses if market selling abates. HOLD

Safe Income Tier

Rating change “HOLD” to “SELL”

Invesco Preferred ETF (PGX – yield 6.5%) – This preferred stock ETF is also vulnerable to rising rates. It also has the added risk of exposure to the banking sector. The rate spike earlier this year prompted several bank failures. These still higher rates may reignite the problem and hurt these shares. The risk/reward is no longer advantageous. SELL

NextEra Energy (NEE – yield 3.3%) – The already downtrodden stock plunged more than 20% over the past week. The harsh performance was triggered by a report from its subsidiary, NextEra Energy Partners, LP (NEP). The MLP announced that it is cutting the projected distribution growth rate from 12% to around 6%. The subsidiary cited higher interest rates for the decision. The concern is that the parent company may not be able to deliver on its earnings and dividend growth projections as a result.

But the development is unlikely to affect NextEra’s growth forecast because it has other ways to recycle capital. Meanwhile, this higher growth utility with a history of market-beating performance is selling at multi-year lows and cheaper valuations than its stodgy utility peers with a now 3.3% yield. BUY

Rating change “BUY” to “HOLD”

USB Depository Shares (USB-PS – yield 5.9%) – This preferred issue has bounced around since being added to the portfolio. It has mostly moved conversely to interest rates but this security has outperformed other investment-grade fixed rate investments. Interest rates continue to spike to new highs. The price will be under pressure if rates continue to rise. Rates are spiking and may continue to rise to a higher level. The security is downgraded to a Hold until rates at least stabilize. HOLD

Rating change “BUY” to “HOLD”

Vanguard Long-Term Corp. Bd. Index Fund (VCLT – yield 4.7%) – There could be some near-term turbulence with the price. This long-term bond fund is vulnerable to rising interest rates. Perhaps rates will be lower than they are now down the road, but they might continue to spike for the foreseeable future. The security is downgraded to a hold until rates at least stabilize. HOLD

Xcel Energy (XEL – yield 3.6%) – This clean energy utility is also struggling near the 52-week low in a very tough market for utilities. XEL had been trending lower since the beginning of April and hit a new 52-week low at the beginning of the month. But the stock has moved off the low. This is one of the best utility stocks to own and things may turn around when the market stabilizes. XEL is still selling near the lowest valuations in years in an expensive market and ahead of a likely slowing economy. BUY