The following comes from a Colorado Bond Manager:
Bob Farrell’s Rules # 7. “Markets are strongest when they are broad and weakest when they narrow to a handful of blue chip names.”
Most stock market participants can remember back to 2000 if they really try. It was common back then for typically risk-averse investors (like retirees) to be insistent that half of their portfolios consisted of Microsoft, Intel, Cisco and Dell. The price of each of these stocks had gone parabolic and none of them paid dividends, which was a good thing because that left them with all those earnings to plow back into their business. If the investor needed to buy groceries, they could just sell a few shares for cash flow.
My, how things have changed. Today, “dividend paying stocks” are all the rage. McDonalds, Proctor & Gamble and Johnson & Johnson are emblematic. Apple has just begun getting into the act by declaring its first dividend and Intel and Microsoft are now on the list after ramping up dividends soon after the tech stock meltdown in the early 2000s.
What these companies have in common is that they are blue chip names and they have taken on a “one decision” aura. For example, Proctor and Gamble has raised its dividend every year for 55 years. These are growth stocks for the most part so dividend increases are expected to continue. And they are usually “global mega-caps”, meaning that they are very big companies that do business (often the majority of their business) outside the U.S. The highest yielding stocks of a more domestic and defensive nature, like the utilities, fail to inspire. It is my opinion that, largely because of the headwinds to growth here at home compared to the emerging markets like China and India, belief in the process of globalization has become linear. There is also a generally negative view toward the value of the dollar vs. the currencies of our trading partners and so all the benefits that accrue to these companies that relate to a weak dollar are expected to continue. A weak dollar gives a boost to multinational companies’ earnings and a strong dollar does the opposite. A weaker dollar also makes our products cheaper and therefore more competitive (and vice versa).
But the current cycle of globalization may be peaking and the dollar may be set to rally. Slowing demand in the developed world, particularly in Europe and Japan is becoming evident and could have a meaningfully negative impact on trade in general and specifically for developing countries like China and India in particular. Protectionism and Isolationism are clearly on the rise as fiscal strains increase and geopolitical fatigue sets in. So the globalization story may not be as bullet-proof as conventional wisdom suggests. But the story does not have to be proven wrong for the stock market to disappoint. For example, Intel retained its status as the global leader in computer chips from 2000 to 2003 even as the stock price dropped from 76 to 13. The flaw in the rationale for stocks that have already performed exceptionally well is often the fact that they command near universal acceptance.
In the case of the blue chip, mega-cap international dividend-paying stocks, the biggest risk to the story may be the belief that a 3% dividend yield will somehow prevent the wild swings in stock prices that we have been experiencing for the last 13 or 14 years. One of the biggest rationalizations for dividend paying stocks is that a 3% yield is 50% greater than a 10 year Treasury bond. But will McDonald’s’ 26 year track record of dividend increases really matter to investors if the price drops from the recent price of 100 to 75 (where it was a year ago)? Will the newly announced dividend from Apple really matter if the stock drops from 640 to 400 (where it stood just 3 months ago)? At least the Treasury bond matures and you get your money back.
Perhaps more to the point, there is very little correlation between stock yields and bond yields. For example, way back in the 1930s, 1940s and early 1950s when the 10 year Treasury bond was last yielding in the low 2% range, the dividend yield on the S&P500 as a whole was frequently over 7%. More recently, in early 2000 when the Treasury bond yield exceeded 6.8%, the dividend yield on the S&P500 reached an all time low of 1.1%. The yield on stocks and bonds are currently about equal at 2.1% and based on yield alone, neither one is particularly attractive. What matters going forward in terms of relative performance is what the price does. In order for the Treasury bond to drop in price, interest rates must rise. (But it still comes due at face value.) In order for Proctor & Gamble to drop in price, well…who knows? In the past, bear markets in stocks have occurred due to a combination of high valuations and generally poor performance in the economy. P&G has raised its dividend at least 4 times since the highs in 2007 and the stock price is down 10%. You have to ask yourself “Do I feel lucky?”
Returning to Rule #7 of Bob Farrell’s “Market Rules to Remember”, there are indications that a handful of blue chip stocks are driving the stock market rally lately and that suggests vulnerability to a more meaningful decline phase. Markets are weaker when one theme dominates the bullish rationale. Honestly, the underlying appeal of stocks today is not the dividend yield at current levels. It is the hope for further price appreciation. Any broadly accepted rationale that the risk of loss is minimized by the dividend yield in the face of dramatic, even parabolic upward price performance should be met with skepticism. The narrowness of the list of favorites adds to the risk.
Recent enthusiasm toward the possibility that the economy was reaching “escape velocity” or a “virtuous cycle” where improving growth feeds on itself has been dampened by stubbornly disappointing economic data. Most recently, the March jobs report produced half the hoped for number of hires and the underlying data was even more negative. There are a number of reasons to expect that the business cycle will be delivering the next recession as the year progresses. Most importantly, household and government debt continue to be enormous and all that debt exerts a deflationary impact on the economy and on asset values. The changes that are required to put the overall economy in a position to expand again will depress demand for many years to come.
These forces should keep the Fed on hold with 0% short term rates for the next 2 years at least and longer term interest rates still have room to fall. The end game for 10 year and 30 year Treasury bond yields are likely to be 1¼% and 2% respectively, roughly 1% lower than today. Tax-free Municipal bond yields may have even further to fall and this means that the Great Bull Market in Bonds is still in force.