Yield curve inversion: How to invest, stocks to buy: Goldman Sachs

The bond market flashed a classic recessionary signal on Wednesday when the 10-year Treasury yield fell below its two-year counterpart.

The plunge in bond yields has increased the appeal of a select group of stocks, according to Goldman Sachs.

The firm's equity strategists also said the market is too pessimistic on this cohort, and specified companies that are positioned to profit investors in a low-yield environment.

The latest yield-curve inversion is not all bad news for investors.

Early on Wednesday, the market's most-closely watched recession indicator was triggered for the first time since 2007: The yield on the 10-year Treasury note slipped below the two-year yield, creating a negative spread that has preceded each of the last seven recessions.

The 10-year yield has plunged by about 40 basis points since July 31, when the Federal Reserve cut its benchmark interest rate. Amid its slide, equity strategists at Goldman Sachs formulated a strategy to help investors find higher yields elsewhere.

They looked into companies that pay plump dividends relative to their share prices, and found that the so-called S&P 500 dividend yield on a trailing 12-month basis was higher than the yield on the benchmark 10-year note. It was the first such occurrence since October 2016.

The allure of dividend payers goes beyond higher yields: These stocks are relatively cheap and have underperformed the broader market since the end of the 2008 financial crisis, according to David Kostin, Goldman's chief US equity strategist.

During this bull run, investors have preferred companies that tend to channel their profits towards future development instead of those that payout shareholders immediately — including so-called growth stocks. Investors' preference has now created a valuation gap between high- and low-dividend stocks that is close to its widest in 40 years, Kostin said.

Additionally, Kostin's expectations for dividends are at odds with the broader market. He foresees S&P 500 dividends-per-share growth of 6% in 2020, up from 3% this year. Meanwhile, swap prices imply that dividend growth will slow to 1% in 2020 from 8% this year.

“Trade tensions have intensified, economic growth has weakened, and earnings estimates have been revised lower during 2019, but we view swap market pricing as overly pessimistic,” he said in a recent note.

This bullish view of high-dividend stocks doesn't fully place them on a pedestal above Treasurys, which are widely considered the safest assets in the world. However, the plunge in yields has increased the allure of stocks that pay higher dividends for the time being.

What's more, the steep drop in Treasury yields means that their prices have become prohibitively expensive for some investors.

“It's really hard to invest in bonds at these prices unless you're Japanese, in which case you're used to it by now,” said John Vail, the chief global strategist at Nikko Asset Management, in a recent interview with Business Insider.

Japanese bond prices have rallied so much that negative yields prevail at every maturity below 20 years.

Vail added that Treasurys will retain their appeal anyway, partly because some investors must buy them to be diversified. But this demand means yields could stay low and possibly turn negative, since yields fall when prices rise.

In this environment of low Treasury yields, Goldman's Kostin says investors should consider the firm's Dividend Growth basket of stocks. The median company in it offers a dividend yield that's 180 basis points higher than the typical S&P 500 stock, at 3.8% versus 2%, he said. Also, the median stock is trading at the largest discount to the median S&P 500 stock since 2016.

The basket's constituents include AT&T, Kohl's, Harley-Davidson, Kellogg, Marathon Petroleum, JPMorgan, and Pfizer.

Kostin also highlighted two exchange-traded funds that track high-dividend payers: the iShares Select Dividend ETF and the ProShares S&P Dividend Aristocrat ETF.