As long-term investors focus on dividend yield, active investors should consider ‘buying the market’ with on the big dips.

Two headlines on a newspaper website, on the same day this week, leapt out. The first, “Sell Everything, RBS Tells Clients”, was about a Royal Bank of Scotland research note that advised clients to prepare for a “cataclysmic” event and up to 20 per cent market falls this year.

The second, “ASX Returns Will Improve in 2016, Macquarie says”, was based on Macquarie Group research this week that predicted a 17% total return (including dividends) on Australian shares in 2016. “… the market can finish 2016 meaningfully higher,” wrote Macquarie.

So one investment bank predicts a 20 per cent fall and tells client to run for the hills and another argues for strong double-digit returns in 2016. Both views are worthy and you can read them on the Australian Financial Review website, if you subscribe. 

The difference between the two forecasts – 37 percentage points of total return in 2016 – shows the growing divergence of views in a volatile market characterised by increasing bearishness.  Uncertainty over China is, understandably, spooking investors. 

Adding to the noise was a forecast from famed investor George Soros that we are on the brink of another global financial crisis; more gloom from Marc Faber that the US economy will slump this year and the world will be in recession; and commentary from respected economist Nouriel Roubini that the European Union is under increasing geopolitical stress.

I can’t recall such a period of extreme pessimism, which formed so quickly, since the 2008-09 Global Financial Crisis, or such a terrible start to a calendar year. But periods of unrelenting bearishness present opportunity for patient value investors.

Focus on yield

I prefer two strategies in this market. Long-term portfolio investors should focus even more on blue-chip companies with defendable dividends: the big-four banks and Telstra are a good place to start. All are well off their 52-week high, expected to yield around 8 per cent this financial year after franking credits, and better placed to maintain their dividend.

The yield looks even more attractive in relative terms. China’s decision to devalue the yuan and signs of a growing global economy will encourage the US Federal Reserve to delay increases in future interest-rate rises. The Reserve Bank, too, will be under pressure to keep interest rates at record lows or probably cut them again in the first half of 2016.

The premium between the average yield on Australian shares and the cash rate will expand this year and encourage savers who are struggling with measly cash rates to buy blue-chip income stocks that can maintain their dividend – or risk being smashed by the market if they cut the dividend.  

Buying the market

As long-term investors focus on yield, active investors who trade more frequently should consider “buying the market” rather than chasing stocks. That is, focusing on an exchange-traded fund (ETF) to benefit as a range-bound Australian sharemarket tests its limits.

I have suggested this strategy in previous heavy market sell-offs: use an ETF over Australian shares to take advantage of period of excessive bearish, in anticipation of short-covering rallies when better economic news emerges and markets stabilise.

The S&P/ASX 200 index has traded between 5,000 and 5,500 points since the start of January 2013, with a few brief exceptions, notably this year when it almost hit 6,000. I was pleased to see the index hold support at the 4,900 level this week and bounce off it, but would not be surprised to see the dip below that level or hover around it. 

The tsunami of bad news and excessive pessimism could take the market through that support point, suggesting the next leg of a bear market. But it’s obvious that value is returning to the market, particularly the big-four banks, and that the turning point in resource-sector valuations, while not here yet, is closer.

The iShares S&P/ASX 20 ETF is a useful tool in this market. In a volatile market, it pays to stick to the largest companies that, ironically, are often the hardest hit first as investors sell more liquid stocks. This ETF has a one-year return of minus 1.63 per cent to December 31, 2015, well down on the 1.96 per cent gain in the iShares S&P/ASX 200 ETF.

iShares S&P/ASX 20 ETF 

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Source: The Bull 

Active investors can use the iShares ASX 20 ETF to trade a bounce in the market when the pessimism subsides. There’s not need to rush in yet, such is the rising “wall of worry” that markets have to climb in 2016 and the lack of a near-term re-rating catalyst.

Watch that 4,900 point on the ASX 200 chart. If the market can test and hold that level several times, I expect the index will test the higher end of its range – 5,300 by year’s end. All bets are off if the index breaks that support point and hurtles lower. But there’s too much value emerging and improving yields in this market for massive falls from here.

If I’m right, active investors who cautiously buy the market using an ETF on heavy-selling days, could achieve an 8 per cent capital gain by year’s end, in addition to 4 per cent of yield, more after partial franking. That gets closer to Macquarie’s 17 per cent total-return target. Moreover, using an ETF for capital growth also means diversified exposure to a basket of stocks as well as yield from the ETF, which is better than the cash rate.

Buying an index fund or a handful of blue-chip stocks for yield is not the most exciting strategy. But anybody who achieves a double-digit return in this market, without taking excessive risk, is doing well. 

 

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Tony Featherstone is a former managing editor of BRW and Shares magazines. The column does not imply any stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at January 14, 2016.