Bond Yields Bounce


Bond yields have jumped to seven-month highs on a few solid economic reports and some early signs of potential inflation pressures. The rate-sensitive utility and telecom sectors have suffered, as have income vehicles like real estate investment trusts (REITs) and master limited partnerships (MLPs).

Among all stocks in the broad Dow Jones U.S. Index, the one-fifth with the highest dividend yields underperformed the average stock in four straight months through May. Among all the variables used to derive our Quadrix Value score, only dividend yield led to underperformance over those four months. That suggests investors are worried about stocks for which dividends are the primary appeal — but still willing to look for bargains amid rising bond yields.

Also encouraging is the resilience of the financial sector, with the money-center and regional-bank groups trading near multiyear highs. Higher interest rates could help reverse the compression in banks' net interest margins, and loan growth for the March quarter was mostly encouraging.

For the broad market, the jump in bond yields since early April has been a nonevent, on balance. Daily advancing stocks in the broad S&P 1500 Index have roughly matched declining stocks, and the S&P 1500 advance-decline line is just a few good days from its May 18 all-time high.

The Dow Transports have bounced but remain more than 8% below their all-time high of 9,217.44. While we are unlikely to become fully invested without a close above that level, we continue to look for opportunities on a stock-by-stock basis. With this week's rank changes, our buy lists have about 85% in stocks.

Stock selections

While Value variables were effective over the past four months, most have struggled over the past year. One notable exception is the price/free-cash-flow (P/FCF) ratio. Stocks cheap on this ratio have outperformed consistently over the past 12 months, and P/FCF also ranks among the most effective of all variables over the past five, 10, and 20 years.

While there is no guarantee that P/FCF will continue to pick winners in the near term, you could do worse than bet on shares of companies that are cheap relative to the excess cash flow they generate. In today's environment, that cash flow is being converted into share buybacks, dividend increases, and strategic acquisitions — all of which are being rewarded on Wall Street.

Among Forecasts recommendations, Affiliated Managers ($226; AMG), Apple ($130; AAPL), F5 Networks ($126; FFIV), Gilead Sciences ($115; GILD), and Shire ($254; SHPG) rank among the cheapest 30% of U.S.-traded stocks based on P/FCF. All five represent top picks for year-ahead returns.

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