NEW YORK (CNN/Money) -
Over the past two weeks, the stock market has been undercut by fears that the Federal Reserve is about to jack up interest rates. Stocks dropped again on Thursday, with losers on the New York Stock Exchange outnumbering winners by more than 4-to-1, as high oil prices and a favorable weekly unemployment report reinforced expectations of higher interest rates.
To a large extent, fears of higher rates are overstated. As I discussed in my April 15 column (see "Don't fear the Fed"), share prices can continue to rise for a couple of years after interest rates turn up.
And despite investors' jumpy reactions, Fed chairman Alan Greenspan has done nothing more than state the obvious. The economy is recovering. Deflation is no longer much of a risk (if indeed it ever was). It would be more cause for worry, in fact, if the Fed weren't prepared to raise interest rates, since that would imply that Greenspan thinks the recovery is about to falter.
Stocks may be okay, but bonds are a different story. The outlook for higher interest rates has already hurt the prices of bonds and some other income investments. So the real problem investors face is what to do if they want high income.
Looking for income
Some retired investors need money to live on. But many more shareholders desire predictable income because it greatly reduces the volatility of a portfolio.
Since 1926, dividends have accounted for more than 40 percent of the return on big stocks. And that part of the return, at least, is not open to much variation or uncertainty.
Trouble is, there aren't many stocks with fat yields in today's market. In addition, while the dividends on most common stocks receive favorable tax treatment, some cash distributions do not, so double-check the tax status of income investments if you're buying for a taxable account.
Some of today's most attractive common stock yields are in the banking sector. Reason: Those share prices are depressed because investors fear that tighter Fed policy will hurt bank earnings.
It's true that banks can suffer from rising rates in two ways -- either because their profit margins are squeezed or because some of their business lines weaken. But these problems are already reflected in the current share prices of the major banks.
So some of these stocks are excellent long-term values, as well as sources of relatively high current income.
Among the Sivy 70, the stock with the most compelling numbers is Washington Mutual (WM: Research, Estimates), with a 4.3 percent yield. Moreover, at $39.80 a share, the stock trades at less than 10 times earnings for the current year.
WaMu is vulnerable, however, because its superior growth over the past five years has depended heavily on mortgage and home-equity loans. Now with mortgage rates rising, those businesses have been crimped. As a result, earnings are expected to be nearly flat this year and gain only about 5 percent next year.
Longer term, though, earnings are expected to rise at an 11 percent compound annual rate. Throw in the stock's high yield and low P/E, and Washington Mutual still looks attractive as a long-term holding.
I'd be more inclined, however, to favor Bank of America (BAC: Research, Estimates), which currently yields 3.9 percent. That bank has much less exposure to mortgage lending than WaMu. In April, B of A reported a 15 percent gain in earnings per share. Those results do not include the bank's acquisition of FleetBoston Financial, which closed in April 1.
Next year, B of A's earnings are projected to rise by at least 10 percent and continue at that rate over the next five years. Considering both growth prospects and yield, the stock looks cheap at $80.10 a share, trading at only 11 times estimated earning for this year and 10 times next year's projected results.
In addition, analysts say that Washington Mutual could be a takeover target and that Bank of America could be acquired by a large foreign bank.
Michael Sivy is an editor-at-large for MONEY magazine. Sign up for free e-mail delivery every Monday and Thursday of Sivy on Stocks.
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