Freaky February: Both Stocks and Treasuries Fall

February should be a bad month. In the 80 years between 1926 and 2006, the S&P 500 returned an average of 0.26% in February. That’s the second-worst month for stock returns, behind September, the only month with an average loss over those eight decades.

In 2009, we've clearly outdone ourselves. The S&P 500 declined 11% in February, on top of an 8.6% decline in January. The Chinese curse "May you live in interesting times" is still upon us.

When you are buying stocks, what you're paying for is a future stream of earnings. And right now, that future stream is shrinking. Goldman Sachs stock market strategist David Kostin estimates that the S&P 500 will see its earnings per share decline to $40 this year. Kostin used that estimate to come up with a target for the S&P 500 of … 650. Yikes.

Sector by sector, it's gruesome everywhere:

Source: Standard and Poor's. As of Feb. 27. YTD = year to date.

Last month, I looked at the January monthly performance of S&P 500 economic sectors in this article linked to here. Of the double-digit decliners from last month, industrials and financials repeated in February. This comes as no surprise, given that the depth of this recession is quite extraordinary, so the most cyclical sectors are affected the worst.

Still, the doom and gloom is so thick that the contrarian in me is uncomfortable being negative on the indexes right now. My view remains that key to a happy end here is the rapid resolution to the banking crisis.

Oddly, technology stands out as a top relative performer, which is surprising given that tech is considered a very cyclical sector. Theory suggests that if you are looking for a safe haven, you should instead be looking for non-cyclical stocks that pay dividends.

Stick with sustainable dividends
Utilities, which were the best performers in January, sold off dramatically in February. One culprit could be the rise in long-term interest rates -- those rates have historically pressured income stocks -- but there's also the issue of deteriorating economic conditions dragging down electricity usage. Be that as it may, at present levels it makes sense to look at some conservative dividend plays in the sector, such as Southern Company (NYSE:SO).

As the name suggests, this electrical utility holding company operates in the South. Over the past five years the shares have traded in a relatively narrow range from $28 to $40, and currently, you can buy them near $30 for a juicy yield of 5.6%. Remember, when looking for yield, the highest dividend yields aren't necessarily the most sustainable -- GE's (NYSE:GE) dividend cut last week is a good example of that. However, Southern Co. is solidly profitable and growing, albeit slowly, and I believe that its stable growth should keep its dividend secure.

Another conservative utility is Dominion Resources (NYSE:D), which yields around 6% and has a very similar profitability and debt structure, yet the stock has sold off quite a bit more. The shares trade at less than nine times trailing earnings, and it's only paying out half its profits in dividends, suggesting its payouts should be sustainable. Other sustainable dividend plays that I have recently mentioned are Teekay LNG Partners, Verizon (NYSE:VZ), and Wells Fargo (NYSE:WFC), although that last one is quite controversial given the numerous dividend cuts in the banking sector.

Time to treasure those Treasuries
Treasury bonds have also seen losses two months in a row, as the money moves to other beaten-down parts of the bond market rather than stocks. After all, if you can get equity-like returns from riskier bonds, why bother with stocks in a highly uncertain environment?

Many have repeatedly called the Treasury market a bubble, arguing that coming inflation and a massive new supply courtesy of deficit spending will pop it and send bond prices spiraling downward. But there is a fundamental difference between money and credit. If you give TARP funds to a bank, but the bank does not lend because of tightened lending standards, you really did not put any new funds into the economy -- and so inflation will not necessarily result.

In fact, until this deflationary mess is fixed, I consider sell-offs in Treasury bonds to be buying opportunities. The iShares Barclays 20+ Year Treasury Bond Fund (NYSE:TLT) has dropped 15% since late December, while 30-year Treasury yields have moved from 2.52% to 3.62%. That should illustrate just how sensitive long-dated bonds are to moves in interest rates.

Looking forward, I don't see the Treasury bond yields headed much past 4% in a deflationary environment, and I can certainly see them going back to 2.5%. So I think this exchange-traded fund (ETF) is an intriguing value right now.

Another good option is the iBoxx $ Investment Grade Corporate Bond Fund (NYSE:LQD). Higher-rated investment-grade corporate bonds are less likely to suffer sharp ratings downgrades. Since many institutional investors cannot hold junk-rated debt, at the time of downgrade they push the price down even further because they have to sell immediately. Higher-rated corporate bonds will hold their own in the current environment. The ETF yields about 6.5%.

Times remain uncertain. In my view, staying defensive with both bonds and stocks is the smartest strategy.

More on stocks and bonds:

• How Low Can Stocks Go?
• The World Won't End
• Are Bonds the Answer for 2009?