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A new year, an old investor dilemma: Is it better to run with last year's biggest winner even though it has gotten pricier, or to shift money into the losers even though they might have further to fall?
This time around, the winner is the U.S. In 2011, stocks broadly stunk and bonds shined, but U.S. issues of both outdid those of most foreign rivals.
There's reason to believe the U.S. will compare well in 2012, too. "We think it's in a major uptrend versus other regions," says Chris Hyzy, chief investment officer of U.S. Trust.
World-wide last year, stocks lost 5.0% while bonds returned 5.5%, judging by two broad benchmarks, the MSCI World Index and the Barclays Capital Global Aggregate Float Adjusted bond index.
In the U.S., a 2.1% total return for the Standard & Poor's 500-stock index last year was a mere crumb compared with an average over the prior half-century of nearly 10%, compounded. But a crumb has rarely been so tasty; euro-zone and emerging-markets shares lost 15.7% and 18.2%, respectively, according to MSCI, an indexing firm.
Mr. Hyzy cites three reasons for his optimism toward the U.S. in 2012.
First, U.S. families and companies have improved their balance sheets in recent years. Household debt has fallen for 13 consecutive quarters, according to the Federal Reserve, and corporations clutch record levels of cash, according to Standard & Poor's.
Second, the dollar is in a "long-term revival" owed to America's diverse and flexible economy, says Mr. Hyzy. The U.S. Dollar Index, which tracks the value of the buck relative to six currencies including the euro, British pound and Japanese yen, rose 1.5% last year after a 1.5% gain in 2010.
Third, U.S. factories are recovering. The manufacturing sector expanded for 28 consecutive months through November, according to a survey conducted by the Institute for Supply Management. That contrasts with China and the euro zone, where some surveys suggest manufacturing has shrunk in recent months.
Poor returns in Europe last year stemmed from a debt crisis among euro members, complete with spiking government bond yields in Italy, Portugal and Spain. Emerging-market declines, while sharp, had a comparatively benign cause; star economies like China and Brazil have seen their growth slow from breakneck rates to merely brisk ones.
U.S. stocks now fetch a premium. They sell for 14 times trailing earnings, versus 11 times earnings in both Europe and emerging markets, according to MSCI.
But John De Clue, head of global investment strategy at U.S. Bank, says the U.S. market is worth the premium and that its shares are cheaper than they have been over most of the past two decades. The S&P 500 index during that span traded at an average of 20 times earnings.
"You have to be pretty brave to bottom-fish now in Europe," Mr. De Clue says. "And while there are good deals in emerging markets, we think the U.S. will lead the way once investor appetite for risk returns."
Earnings underlying the S&P 500 index are expected to increase 10% in 2012, according to a consensus of Wall Street estimates published by Standard & Poor's.
Investors debating whether to make portfolio changes this year should start with a straightforward decision: whether to sell bonds. Their outperformance last year will have left many portfolios with larger-than-intended bond weightings. And yields are skimpy enough to make saying good-bye painless. The 10-year Treasury yields 1.88%, less than one-third of its average of the past half-century.
In deciding which types of bonds or bond mutual funds to keep, investors may want to favor one of last year's top performers. Tax-free municipal bonds, issued by states and local governments, defied fears of widespread defaults last year and attracted investors searching for yield. The Barclays Capital Municipal Bond index ended 2011 with a 10.7% return.
Don't expect anything near as generous from munis this year, says Richard Ciccarone, chief research officer for McDonnell Investment Management, a Chicago-area bond specialist. But their yields remain more attractive than those of comparable Treasurys and corporate bonds, he says.
For example, among 10-year bonds with the highest credit ratings, municipals recently yielded 1.9% and corporate bonds, 2.1%, according to data provided by ValuBond, a research firm. But municipal-bond income generally escapes federal and some state taxes. Even an investor who pays 10% in federal taxes would find the municipal yield slightly more attractive.
As for which U.S. stocks to favor, Messrs. Hyzy and De Clue agree on the appeal of dependable dividend-payers.
"The search for yield will be the greatest theme for the next few years," says Mr. Hyzy, who likes utilities and real-estate investment trusts, or bundles of investment property that trade like stocks. Mr. De Clue likes technology and manufacturing firms with global exposure, and energy producers, which he says stand to benefit from a recent rise in crude oil prices. Crude-oil futures rose 8.2% on the New York Mercantile Exchange last year.
High-yield shares did relatively well in 2011. The Vanguard High Dividend Yield Index (vhdyx) fund returned 10.4%. But rising dividends might be more important than merely high ones, says George Fraise, a principal with Sustainable Growth Advisers, a Stamford, Conn., money manager.
According to Mr. Fraise's research, U.S. companies with healthy dividend increases between 2000 and 2010 outperformed those with high yields but only meager dividend increases.
Dividend-payers stand to benefit in coming decades from an event that has only just begun the retirement of the baby boomers, according to research by Savita Subramanian, chief U.S. stock strategist at Bank of America Merrill Lynch.
For stock pickers looking for rising dividends, there are plenty of choices. According to Standard & Poor's, 132 members of its S&P Composite 1500 index of large, medium and small companies have increased their dividends for at least 10 consecutive years.
The list includes medical-goods supplier Cardinal Health (CAH) Inc.; ConocoPhillips (COP), an oil and gas producer; Illinois Tool Works (ITW) Inc., a diversified maker of industrial goods; century-old computing giant International Business Machines (IBM) Corp.; and railroad operator Norfolk Southern (NSC) Corp.
Members of a more elite group, the S&P 500 Dividend Aristocrats, have increased their payments for at least 25 years running. Among them are household names like Exxon Mobil (XOM) Corp.; New York City's power company, Consolidated Edison (ED) Inc.; Johnson & Johnson (JNJ); McDonald's (mcd) Corp; and Wal-Mart Stores (wmt) Inc.
For mutual-fund buyers seeking high and growing income, the Dow Jones Select Dividend Index Fund, distributed by iShares, is an exchange-traded fund with a mechanical approach. Membership in the index it tracks is determined by computer screens for items like past dividend increases, dividend affordability and high yields. The fund holds 101 stocks, with heavy concentrations in utilities, consumer goods and manufacturers. Expenses are a moderate $40 a year per $10,000 invested, and the fund recently yielded nearly 4%.
An open-end mutual fund, T. Rowe Price Dividend Growth, offers stock-picking performed by man rather than machine. It yields less (1.5%) and costs more ($68 per $10,000), but over the past 10 tumultuous years has returned 3.7% a year, besting the S&P 500 by nearly a percentage point, according to Morningstar. The performance ranks among the top 15% of large-company, blended funds in Morningstar's database.
Says Mr. De Clue, "Dividends played a big part in deciding whether investors were flat or up in 2011, and they're going to remain important."
Table Sources: WSJ research, * Organization for Economic Cooperation and Development ** MSCI
A high dividend yield is only as good as a company's ability to continue making payments. Here are signs to look for:
Earnings that safely exceed dividend payments. The more volatile a company's earnings tend to be, the larger the cushion it needs.
A recent dividend increase. Managers are generally loath to cut payments, so a recent increase suggests confidence in continued ability to pay.
Rising sales and earnings. Dividends are ultimately linked to company prosperity, so thriving companies are safest.
A yield that's not suspiciously high. It could be a sign that investors anticipate a payment cut.
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