Large-Cap Dividends a Value Trap?

Eric Roseman (July 13, 2010)

Don’t Fall for It! But Here are the 5 I Do Recommend…

Viva Las Vegas!

Last week I spoke at FreedomFest in Las Vegas, and I was thrilled to be able to connect with several Sovereign Society members there.

For those who couldn’t make it, FreedomFest is the single event where you will find the greatest concentration of Libertarians, and bears.

Big-gun speakers of the past include Texas Rep. Ron Paul and my personal favorite Doug Casey.

But fun and freedom aside, whenever I am in Vegas I make it a point to “interview” locals to get a feel for their perception of the economy.

My, How the Sentiment Has Changed!

This is my third visit to Las Vegas in less than a year. And I always ask merchants, hotel clerks and taxi drivers how business is doing.

A year ago, the stores and restaurants on Las Vegas Boulevard were almost deserted and my interviewees were miserable.

But my latest survey of last Wednesday found a joyful mood among my leading indicators. Taxi drivers told me how busy it’s been here recently, including the July Fourth weekend. And the Bellagio Hotel where I stayed was packed.

I’m Calling it a Bear-Market Rally

But when I walked into Bally’s, where FreedomFest was hosted, I saw heart-stopping caution toward the economy and the markets.

This conference should be a contrarian’s dream because virtually everyone is tired of big government, fiscal deficits, the dollar and the direction of the Obama economy. Delegates here are convinced Obama is a one-term president and that he’ll sink the economy.

Under normal economic circumstances, I would have interpreted this crowd’s sentiment as seeing a buying opportunity for stocks and a bearish signal for hard assets like gold, silver and other raw materials.

But not this year.

I would call this the most dangerous market environment since 2007-’08.

Most investors still fail to appreciate the grave danger unfolding in Washington regarding policy initiatives, financial reform (i.e., barely any reform at all) and the growing fiscal crisis spreading across most states and municipalities.

Stocks mustered a long-overdue rally last week, which should come as no surprise following weeks of heavy selling.

Last week’s big gain for U.S. averages was accompanied by unimpressive volume, and there were more new lows than new highs!

I’m a bear and would use any rally to unload unwanted equity risk and add to intermediate- and long-term Treasury bonds as prices ratchet higher this week.

I remind investors that, with the exception of 2009 – a massive bear-market rally – most summers since 1997 have been marked by big declines in asset prices.

Governments have a habit of unloading bad news in the summer.

The primary trend of the market since May is down.

The economic backdrop has deteriorated markedly over the past eight weeks with unemployment stubbornly high, bond yields triggering a sell signal for risk assets and Treasury Inflation-Protected Securities’ (TIPS) break-even rates crashing to levels unseen since the depths of the credit crisis in late 2008.

The sovereign debt crisis in Europe has just begun. There is more pain ahead for the Eurozone.

Deflation is accelerating across Europe – and that alone will provide a huge gap in global demand over the second half of the year. This leaves the United States, Japan and China as the world’s consumers of last resort. And that’s not a bullish picture.

Let’s Talk Numbers…

Are investors better off buying large-cap stocks paying a 4% dividend over the next 3-5 years or buying a 10-year U.S. Treasury bond yielding 2.96%? What would you rather own?

If we’re struggling with renewed deflation now, then inflation won’t be a primary concern for the next few years. That’s what Treasury bonds and TIPS are telling us now.

It’s also the message derived from the yield-curve where short-term and long-term interest rates are compressing at their fastest rate since late 2007.

Credit doesn’t lie. The market is beginning to price in a slowdown.

David Rosenberg of Toronto-based Gluskin-Sheff accurately called the bond rally.

Rosenberg was one of the few bond bulls heading into 2010 — believing a heavily leveraged American economy would act as a drag on economic growth.

He doesn’t believe Treasuries are in a bubble, either. Long-term Treasury bond prices have soared 23% this year.

The U.S. broader market (as defined by the S&P 500 Index) opened last week 16% below its post-March 2009 high and yields 2.14% in dividends. U.S. equities recently posted their worst skid of consecutive loss since October 2008.

Another 4 percentage points lower and we’re technically in a new bear market!

Investors define a bear market for stocks as a loss of 20% or more. On that measure, several indexes are already in bear-market territory, including banks, oil services and energy stocks, telecoms, retail, etc.

Foreign stocks as measured by the MSCI EAFE Index (which includes stocks from Europe, Australasia and the Far East) are also technically in a bear market. The MSCI World Index is just a few points away from that infamous threshold.

But as stocks have declined sharply over the last five weeks, dividends have risen for some of the largest stocks in the S&P 500 Index.

There are a Few Great Values Now…

Many large-cap companies also hold a tremendous hoard of cash – north of $850 billion dollars and the most in nearly 20 years. Indeed, some of these companies have boosted buybacks this year and hiked dividends.

Amid the growing nervousness out there this summer I wonder if an investor looking out three years or more might be better off buying and holding the likes of Johnson & Johnson (3.7% yield), Coca-Cola (3.5%), Kimberly-Clark (4.4%), Eli Lilly (5.8%) or ExxonMobil (3.1%) compared to sitting at near-zero-percent money markets or lowly T-bonds?

Unfortunately, barring a short-term rally, stocks have further to drop before really offering outstanding values. They didn’t offer exceptional values in March 2009 and they certainly don’t offer great values now, either.

Exceptions, however, abound. The above five large-caps are attractive at these levels and are trading near their 52-week lows. Combined, the five yield an equally weighted dividend of 4.1%.

Dividends, though attractive at these levels for many large-cap non-financial companies, also face the uncertainty of tax hikes in 2011.

Nobody really knows where the new Obama dividend and capital gains tax rates will stand next year – and investors hate uncertainty.

Energy stocks are cheap; but again, the fallout from the Justice Department’s witch-hunt and the reverberations of the BP disaster in the Gulf also raise uncertainty.

One thing is certain. The V-shaped economic recovery in the United States isn’t happening.

The economy is running out of steam and the second half of 2010 doesn’t look too encouraging. This assumes corporate earnings expectations are too high and the market might have further to adjust.

That doesn’t mean you have to get out of the market and wait for supposedly “better days.” If that were the case, most investors would go to cash and never return!

There are always opportunities to be found to which you can allocate fresh capital, but don’t forget to protect what you already have, as well.

If you choose to bargain-hunt amid a falling-knife market, then be sure to apply stock-hedges to your longs. We may face a bear market for the first time since October 2007. And most large-cap stock dividends will get much cheaper.

Eric Roseman
Investment Director, The Sovereign Society

Editor’s Note: My “Chaos Portfolio” was created as a hedge for uncertain markets, and it’s performed beautifully over the last few years. And I’m giving it a special makeover in the August issue of The Sovereign Individual. If you’re not already a Sovereign Society Member, you can join now to ensure you hold this important hedge in your portfolio.