Beware the Dividend Trap

The Dow finished down 250 points in the US on Friday, or nearly 1.5%. Gold was up nearly US$25. Just like old times!

Apparently, the fall in US stocks had something to do with weaker–than-expected fourth quarter economic growth numbers. Real GDP grew by 2.6% annualised compared to 5% growth in the third quarter.

Of greater concern was the sharp drop in ‘real final sales’, which seeks to measure underlying demand in the economy by removing the effect of inventory growth or depletion. On an annualised basis, real final sales growth was just 1.8%, down from 5% in the third quarter.

Clearly, there was a noticeable slowing in US economic growth at the end of last year. But GDP data is a lagging indicator, so whether it really influenced the market on Friday is questionable.

As I wrote last week, the US market looks like it’s in a correction/consolidation period…regardless of the data flow. Let’s take a look at Dow Jones index…it’s been a while since you’ve seen it here.

Over the past three years, the Dow has rallied strongly. After a sharp correction in October, the index surged to new highs in early and late December 2014. But it’s since fallen again. If the Dow falls below the mid-December low of around 17,000 points, it could quickly lose another 1,000 points and head toward the October 2014 low.

Given the size of the advance over the past few years, such a correction would not be unusual. However, the bears will come out growling should the Dow break the October low, as such a move would signify a much deeper correction is on the cards.

What could be the cause of the current correction? The strong US dollar comes to mind. The Dow is full of multinational companies that earn a decent amount of revenue and earnings from foreign markets. The strong dollar, combined with slowing growth in these markets, will have an effect. Perhaps the market is starting to price this in?

This won’t come as a surprise to subscribers of Phil Anderson’s Cycles, Trends and Forecasts report. Phil’s been preparing his readers for a correction (not a crash) in early 2015.

It’s a different story in Australia though. There’s a whiff of an interest rate cut in the air and investors love it. In recent weeks, Australia’s bellwether financial stock, the Commonwealth Bank [ASX:CBA], broke out to a new high and briefly touched $90 per share.

The reason is simple. Lower official interest rates translate into the prospect of more housing market speculation, which CBA will benefit from. In addition, the lower cash rate makes the banks’ dividend yield more attractive, so the share price rises as investors ‘chase’ this yield.

That’s why Telstra’s [ASX:TLS] share price is at multi-year highs. Investors are treating these yield stocks like bonds that have an almost guaranteed income stream, not equities where the dividend is variable.

That’s all well and good while earnings grow and the dividend is at least maintained. But as soon as there is an earnings hiccup, the share price will be in trouble.

Take Woodside [ASX:WPL] for example. There is a story in the Financial Review today about how investors saw it as a dividend stock and piled in.

Based on 2014 dividends of $3.06, the stock currently trades on a historical dividend yield of nearly 9%. Even at the peak price last year of around $44, it traded on a yield of nearly 7%.

But this is a resource company we’re talking about. You should never buy a resource stock for its yield. In fact, whenever the yield on a resource company grows in excess of 4-5%, it’s a sign that the market doesn’t believe it’s sustainable.

That was exactly the case with WPL. Dividends are likely to halve this year…and even that is being optimistic. The stock price has fallen a relatively benign 22% from its peak in August last year. There’s probably more to come. Here’s why…

Based on consensus earnings estimates for 2015, WPL trades on a price-to-earnings ratio of 18. That’s expensive. It means investors clearly think oil prices and profits will rebound pretty quickly.

If the oil price doesn’t rebound, expect WPL’s share price to fall much further this year. Based on the current oil price, the stock is very expensive.

The risks of investing in energy-related stocks versus banks or Telstra are clearly different. But the point is, when a stock trades more like a bond than equity (a part ownership in a business with variable earnings and dividends), then risks increase considerably.

For example, nearly everyone thinks that the RBA will cut interest rates tomorrow afternoon. For the past few weeks, the market has been moving higher on the assumption that lower official interest rates will make stocks more attractive. Lower rates are already factored in.

So the big risk is that Glenn Stevens doesn’t deliver. On Friday, I explained why Stevens might disappoint the market. I’m sticking with the no rate cut call and if he indeed keeps rates on hold for another month, you can expect a market sell-off.

Along with expected weakness coming from US markets (mentioned above) that could mean the Aussie market is in for another correction too.

In other words, same old, same old. For the past six months, increasing volatility has characterised the Aussie market. Big rallies have followed big sell-offs. Thanks to the prospect of more interest rate fuel, the market is back near the highs reached in August last year. It’s probably time for another pull back.

While I don’t think the RBA will cut tomorrow, given the dire state of the Aussie economy, I do expect more cuts in 2015. It’s only a matter of timing. And as long as the blue chip stocks maintain their earnings and dividends, lower interest rates should put a floor under the market.

That’s assuming nothing else pops up to worry investors, which is a big assumption. Keep your eye on Greece and Europe, dear reader. That’s where the action is right now.

Greece is the key to the whole Eurozone project. If Greece is serious about reducing its debt and not just being dictated to by its creditors, you’re going to see some fireworks in Europe soon.


Greg Canavan+
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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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