That was close.
The U.S. stock market has escaped the sell-off in the Japanese marketat least for now. When the Nikkei Stock Average dropped 7.3% on Thursday, the Standard & Poors 500-stock index fell by as much as 1.1% during the day, only to finish down a hair.
Highly leveraged companies [those with high levels of debt] have done extremely well in the past three years, says Harindra de Silva, a portfolio manager at Analytic Investors, an investment firm in Los Angeles that manages $8 billion. But they have the potential to really hurt you going forward.
A rotation already might be under way; suddenly, the safety trade is faltering. Real-estate investment trusts, utility stocks, high-dividend companies and low-volatility stocks (which move up and down less sharply than the market as a whole) all have been performing spectacularly welluntil this month, when they started to fade. Many such companies, which investors have been buying for their perceived safety and income, have borrowed heavily.
The S&P 500, up 12.7% in the first four months, has added another 3.5% in May . Stocks with high dividends, as measured by the SPDR S&P Dividend exchange-traded fund, crushed the market with a 16.4% return through April; in May, however, they fell behind, adding less than 3%. Low-volatility stocks, up 15% and more until this month, stayed flat in May. REITs, with a 15.4% gain through April, have lost 1.2% so far this month . And utilities, which returned 19.9% in the first four months, have fallen 5.6% in May.
The conservative stocks had done so well and gotten so expensive, Mr. de Silva says, that its almost like people have started saying, Well, if everythings going to go up, I might as well buy the cheaper, riskier stocks now.
Consider that at the end of April, utilities were trading at 22.9 times their earnings over the past year and low-volatility stocks at 24.9 times, versus 21.2 times for the S&P 500. High-dividend payers were trading at 17.2 times their projected earnings over the next year, with the S&P at 15.1 times next years estimates.
History shows that whatever is stretched tends to tear when interest rates rise.
On Feb. 4, 1994 , the Fed jacked up rates in the first of what would turn out to be five increases that year. Then, as now, the backdrop was a period in which money the Fed has been so generously creating has been flowing into securitiesand may have been creating a securities market bubble, as The Wall Street Journal wrote the day after the first rise in rates.
That day, the Dow Jones Industrial Average tanked 2.4%partly, wrote the Journal, because of uncertainty about how far the Fed will go.
The biggest fear of investors then was that the Fed would tank the markets, which still were recovering from the recession of 1990-91. That didnt quite happen; the U.S. stock market overall earned 1.3% for the full year in 1994.
But the damage was widespread, hitting supposedly safe and risky assets alike. For the full year, utility stocks lost 15.3%; municipal bonds, 5.2%; emerging markets, 8.7%; intermediate-term Treasurys, 5.7%; the U.S. bond market as a whole, 2.9%; gold, 2.2%. REITs eked out a gain of 0.8%; without their generous dividend yield of roughly 7%, they would have lost 6.4%. (The average yield on REITs today is a bit over 3%.)
There was no index of low-volatility stocks back in 1994, but Mr. de Silvas research shows that in periods of rising interest rates, these stocks tend to underperform the market as a whole by an average of about 0.8 percentage point annually.
This past weeks tumble in Japan confirms the lessons of 1994. Just the thought of what will happen when a central bank tightens the faucet of easy money can spook investors.
REITs, dividend-paying companies, utilities and low-volatility stocks all have a place in a portfolio. But they arent worth paying a premium price forand, as safe as they have seemed until recently, they wont offer blanket protection once the fear of rising rates becomes reality. The many investors who have been overloading their portfolios with this kind of safety may soon be sorry.
Write to Jason Zweig at intelligentinvestor@wsj.com or follow him on Twitter: @jasonzweigwsj