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It seems like investors are darned if they do and darned if they don't right now. Do I buy and hold good companies? Do I try and trade this market? Or do I raise cash and guarantee I make no money?
Arguably the idea of buying solid, high dividend companies for the long-term and paying no attention to the short term noise has never made better sense than it does today. Generally speaking, the balance sheets of these companies are very strong and so the dividends are pretty safe. However, there are two problems with this strategy.
First, the challenges in ‘macro land’ are many, so the odds are greater than zero that another ‘market event’ happens, side-swiping fully invested, long only equity investors. As folks learned -- twice now during the 21st century -- if you lose 25 percent of your money, you need to earn 33 percent just to get even.
In addition, as investors chase yield, these 'safe' dividend stocks have become quite expensive. In fact, in many cases, the price-to-earnings ratio of the highest yielding stocks is higher than the valuation accorded pure growth stocks, stocks that typically don't pay dividends.
And, by the way, I don't buy the argument that the stock market is 'cheap'. It’s trading at its current valuation because the three year earnings outlook is okay, but not great, and the demand for equities is weak relative to supply, as evidenced by continued redemptions from equity mutual funds.
Anyway, back to the other way to make money from owning high dividend paying stocks -- and that is for earnings to rise. Unfortunately most companies have passed their peak in earnings growth for the next couple of years. After the financial crisis, the combination of cost cutting and the revenue growth, catalyzed by fiscal and monetary stimulus, combined to push profit margins to record levels, taking earnings back to pre-crisis levels.
But the slowdown in the second half 2012 that I've been talking about since late 2011 is now upon us. With so much debt in the system and an aging population in the western world, it's irrelevant what the politicians try and achieve, as we're stuck with below trend growth for a good while longer. On top of the low earnings growth implied by this economic scenario, interest rates aren't going to be the savings grace for investors looking for income – and there are two reasons for this.
First, rates will remain anchored at these low levels for years for a good and a bad reason. The good reason is to try and stimulate spending; the bad reason is can you imagine what a disaster consumer and government balance sheets would become if rates were allowed to rise? Just think what would happen to the U.S. and Canadian housing markets if interest rates doubled from current levels to what would still be low levels.
The other reason low rates won't be the saviour for investors was shown by the markets last week. Look at the lack of positive price action in risk assets after the Chinese and European Central banks cut interest rates, and the UK extended their program of quantitative easing. The markets just yawned, realizing that monetary authorities are 'pushing on a string'.
So what's the answer? Well it depends upon your individual needs for cash flow from your portfolio, appetite for risk and desire for trading off the potential for capital gains against preservation of capital.
In my view, just like in the housing market, returns are cyclical. Simply put we're in a period when financial assets are not going to pay you much of a return; and you just have to accept that. As a result, generally speaking. it’s wise to concurrently cut down on the risk you are assuming when you construct your portfolio, so that your potential return and assumed risk are aligned.
As a result, a balanced portfolio may include a good cash reserve, corporate bonds, and solid companies offering dividends. If you're willing to do the work, identifying a mutual or hedge fund which is run by a manager who has a track record at preserving capital might make sense too, as often professional managers have more 'tools' to play with in implementing their investment mandate.
Remember, we'd all like to make more money, but you can't fight the tape!