Vern Gowdie – The Daily Reckoning (Australia) –
The confidence indices are moving in tandem with the Dow Jones. Everyone is on a high.
The term ‘record levels’ seems to stir the animal spirits.
Which, to me, is complete madness. There’s a good reason we have records.
It’s because this is territory we’ve never ventured into before.
And, when it comes to markets, records are a pretty reliable indicator of the ‘beginning of the end’.
Yet most people interpret it a sign of safety…there’s more where that came from.
Previously, when markets have pushed through psychological barriers — 1000 points, 10,000 points, and so on — record-chasing investors have been sadly disappointed. In 1999, the Dow went through the 10,000-point barrier during the height of the dotcom boom. The last time the Dow went through the 10,000-point mark was in 2010…11 years later.
My guess is that we’ll see a repeat of this in the coming decade. The Dow is unlikely to permanently breach the 20,000-point level until the late 2020s.
In last Friday’s Daily Reckoning, I made the case for how the Dow could possibly fall 80% in value in the coming years. In the current environment, this is a laughable proposition. Complete fantasy.
The same scenario could have been put to the bullish crowd in early 1929 and been greeted with the same derision.
But that was then, and this is now. The world is different. The Fed will not allow this to happen.
And that’s the investors’ Achilles heel…absolute belief in the Fed and its powers of redemption.
What if the Fed is powerless to stop the next correction? This is not as preposterous as it sounds.
There are a number of heavy hitters in the US market who’ve publicly expressed doubts about the Fed’s ability to ‘raise the market from the dead’.
‘We can no longer rely on central banks… They’ve done all they can do and a bit more,’ says Mohamed El-Erian, chief economic adviser at Allianz and former CEO and co-chief investment officer at PIMCO.
‘Major central banks have run out of ammo,’ notes Ed Yardeni, chief investment strategist at Yardeni Research.
To ignore the possibility of an impotent Fed could be a very costly mistake.
Don’t rule out a plummeting stock market
In response to Friday’s Daily Reckoning, a reader sent me the following email:
‘Love your work and thanks to your [sic] guidance both in prior years and at the recent Port Douglas conference am only currently 100% invested in the market. [Normally would be (remember Storm Capital) 2x geared] BUT: Really, what do I care if the overall market crashes 50-80%? ………..so what? To your point, top 50 profits aka dividends continue apace. Like a house, no loss if you don’t sell!
Not sure if the first part is a backhanded compliment — ‘love your work, but I’m 100% invested in the market.’ Hmmm, still trying to figure that one out!
Anyway, the real take-away from the email is: ‘50–80% crash, so what?’
Dividends continue apace.
My interpretation of this is that, if my capital falls, it is of no relevance as I am not a seller; it’s the dividends (income) that are important to me.
At face value, that appears to be a fair point. However, it’s a mindset that’s evolved from the greatest secular bull market in history…an expectation of dividends continuing.
It was Edmund Burke who said, ‘Those who don’t know history are doomed to repeat it.’
The following table shows the earnings of the S&P 500 for the period 1929 to 1949.
[Click to open in a new window]
In 1929, the index produced average earnings of US$22.60…three years later earnings had fallen by two-thirds, to US$7.56.
It took nearly 20 years for earnings to reach the US$22 level again.
When a share market suffers a fall of 80%, you can rest assured that there will be economic consequences. People have less money to spend. Less money going through the cash registers means smaller corporate profits.
If businesses are earning less, guess what happens to dividends?
They are reduced, or even cancelled.
In Barrie A Wigmore’s rather lengthy book, The Crash and Its Aftermath: A History of Securities Markets in the United States, 1929-1933, there’s a treasure-trove of data on what happened to stocks during the Great Depression.
The table below shows a selection of blue-chip companies at the time of the Great Depression; it shows the percentage of decline in each company’s stock price from 1929 to 1933, as well as the dividend the companies paid out in 1933.
|Company||% fall from 1929 high||% dividend paid in 1933|
|Sears Roebuck||93%||No dividend paid|
|Colgate-Palmolive||92%||No dividend paid|
|BF Goodrich||94%||No dividend paid|
There was some serious carnage to capital values. Not sure about you, but, personally, I would be affected by losses of this magnitude.
But let’s put the psychological impact of capital losses to one side and focus on the dividends.
You could say that the higher yields being paid by some — not all — of the companies are proof that if you sit tight and receive the income, all will be OK in time.
Nothing in markets is what it seems at first sight.
Let’s look at the highest payer: Gillette. From 1929 to 1933, Gillette fell 95% in value and was paying a 13.77% dividend in 1933.
To keep this exercise simple, we’ll work with whole numbers (the dividend is rounded to 14%).
|Company||Share price||Dividend %||Dollar amount of dividend|
An investor who believed that, irrespective of capital values, ‘dividends would continue apace’ was receiving a 70-cent dividend in 1933 on their 1929 $100…an income return of 0.7% per annum.
Not only have they suffered a 95% reduction in capital, their income has fallen over 80%.
Whereas the investor who waited patiently in cash would be buying 20 shares for the price of one AND receiving a 14% income.
When the inevitable recovery does come, they have 20 times the number of shares taking that upward ride. In the meantime, they’re being paid 14% for their troubles.
Sounds a whole lot better to me than the alternative.
Granted, this is an extreme…but, the fact is, it did happen.
Could it happen again? Yes, but possibly not to the same extent.
However, the purpose of the exercise is to show that dividends do not operate in a vacuum. If underlying profits are impacted due to a slowdown in economic activity, dividends suffer. They do not magically stay divorced from reality.
In the last secular bear market — 1966 to 1982 — S&P 500 earnings fell from US$41 to US$31.
The problem is that, after 35 years of market and economic expansion (courtesy of the greatest credit bubble in history — even greater than the one that triggered the events of 1929), investors have become conditioned to believe in the ‘buy the dip’ and ‘dividends will continue apace’ mentality.
History categorically does not support these beliefs.
In fact, the very existence and expression of these ‘beliefs’ should be a warning signal that all is not right. The discounting of risk, at precisely the time when the markets are at record highs, spells D-A-N-G-E-R.
The time to be buying is when markets are at records lows. But people don’t have money then. Why? Because they buy in at record highs and believe that ‘this time’ is different.
Which is why those who don’t know history are doomed to repeat it.
In my opinion, there should be far better dividends on offer for those who play it safe…that’s what history tells us.
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