Monday, June 29, 2015

3 Headwinds for Dividend Stocks: Will They Continue?

This blog was written prior to today's news about Greece. Based upon everything we see thus far, the Greece situation has short-term implications, but not long-term. Investors and financial institutions have had seven years to get used to the prospects of a Greek default. Furthermore, Greece represents only 2% of the European Union, which is a fraction of the global economy. We will have more to say on this over the next few months.

Dividend investors have had a difficult time so far this year.  While the S&P 500 Index has risen 3.0% on a total return basis, the Dow Jones Dividend Index is down 2.2% and the Vanguard Dividend Achievers Index is down 0.4%.  As usual, the nay-sayers are neighing that dividend investing is dead. But whoa Nellie, there have been three disparate forces that have pulled in the reins on stocks with higher than average dividend yields:

1.       Rising long-term interest rates
2.       Sharply appreciating U.S. Dollar versus most world currencies
3.       Collapsing energy prices

In many ways, the confluence of these three forces is unusual and not likely to last.  Over the last 20 years, long-term interest rates have been negatively correlated with oil prices and oil prices have been negatively correlated with the dollar.  One or two of these economic measures would be rising in a "normal" environment, but not all three at the same time.  It would be highly unusual if these three price trends continue in the same direction for much longer.

As strange as this time has been, the result has been clear. The current trend of these three economic measures has had a negative impact on many of the most important stock market sectors for dividend investors:
  • The rise in interest rates has hit the prices of the utilities, REITs, and telecoms sectors in much the same way as it has bonds.  
  • The rise in the dollar has significantly lowered multinational companies’ earnings and dividend growth, along with their stock prices.  
  • The collapse in oil prices has sent big oil and pipeline stocks down by as much as 30%.
The only sector with higher than average dividend yields to escape the adverse prevailing forces has been the financials, whose net interest margins and profits normally improve with rising interest rates.

As dividend investors, we have been facing all three headwinds for the last six months.  The question most of us are asking is, “How much longer can the headwinds last?”

Here is our view of these trends over the short and intermediate-term trends:

Interest rates:  With Greece teetering on the edge of default, we expect money will be in a flight-to-safety over the near-term.  This will push U.S. Treasury yields lower and allow for a modest rally in interest-sensitive stocks such as utilities and REITs.  How long the rally prevails will depend on how long it takes for the markets to digest the final outcome of Greece.  Regardless, we expect long-term interest rates will slowly move higher once the crisis is over. 

Oil prices:  The supply and demand of oil is nearing equilibrium. If that is the case, oil prices may have seen their lows.  Despite their rally in recent months, they are still 40% lower than a year ago. We have difficulty believing that a rally in oil stocks is near.  The Greek tragedy is a deflationary event. If it lasts very long, we would expect oil prices to trend lower. Furthermore, we will likely see some negative surprises from those oil and pipeline companies with high debt loads.  The companies in our portfolio are of the highest quality in the industry, which means they are in better shape to handle sustained low oil prices than their peers.

U.S. Dollar:  The flight-to-safety we spoke of would benefit U.S Treasury bonds and should also push the U.S. dollar higher.  The Greece concerns may not be a long-term occurrence, but will continue to produce near-term headwinds to most big multinational companies’ earnings and dividend growth.

Our analysis of the headwinds that have held back the performances of many great dividend stocks in the first six months of the year suggests that the second half will be modestly better than the first. However, we don’t see big moves in interest rates, oil prices, or the value of the dollar.

Companies that can produce double digit earnings and dividend growth in this environment will be highly prized.  We will continue to favor higher dividend growth versus higher dividend yield in the coming months.  We particularly like companies that derive more than 60% of their earnings in the United States. These kinds of companies are not as sensitive to the movements of the dollar as are the multinational stocks.  In addition, their higher growth can trump changes in interest rates.

In addition, most of them are benefactors of lower oil prices.  As long as these companies can produce above average earnings and dividend growth, we believe investors will continue to push their stock prices higher. We'll talk about some of our favorites in future blogs.

Finally, a near-term modest fall in interest rates would seem to be a negative for the financials.  In addition, they have all experienced strong price growth year to date.  With the trouble in Greece filling the headlines, we would not be surprised to see the financials tread water for a few weeks to months.

The Greek tragedy seems to be a never ending story that will lead surely to a catastrophic ending, but investors have had five years to get out of the way of a doomsday scenario for Greece.  We doubt the effects will be long lasting.