EXECUTIVE SUMMARY FOR THIS SERIES
High-yield stocks are a form of cash. Thus inflation eats away at both yield and principle. As governments inflate their money supply to ease credit, most oberservers believe inflation is inevitable.
In this series we explore:
- The current state of the market
- The case for and against the dollar's demise
- Recommended criteria for selecting high dividend stocks that also give a hedge against the U.S. dollar's likely impending depreciation.
Specific stock market hedges and high dividend stocks that are inflation-resistant mentioned below include:
GENERAL MARKET HEDGES
Canadian Oil/Gas Energy Income Trusts
Canadian Clean Energy Income Trusts
Canadian Energy Infrastructure Income Funds
Canadian Utility Income Trusts
Canadian Health Care Income Trust
CML Healthcare Inc. Fund (OTC:CMHIF, TSX: CLC.UN)
Canadian Real Estate Income Trusts
Canadian Misc Business Trusts
Yellow Pages Income Fund (YLWPF.PK)
Energy Infrastructure Master Limited Partnerships (MLPs)
Buckeye Partners (BPL), El Paso Pipeline Partners (EPB), Enterprise Products Partners (EPD), Energy Transfer Partners (ETP), Kinder Morgan Energy Partners (KMP), Magellan Midstream Partners (MMP), Nustar Energy (NS), ONEOK Partners (OKS), Sunoco Logistics Partners (SXL), TEPPCO Partners (TPP),Tortoise Energy Infrastructure Partners(TYG)
CURRENT MARKET STATUS
Before ever considering investing in stocks, we must always first look at the overall market, since almost all stocks follow the major indices.
- The Short Version
Still trending down, invest only funds not needed for the near term expenses. While there may be rallies, even multi-week or month ones, the fundamental problems remain and there is no credible plan to fix them at this time. News driven and thus even more unpredictable than usual.
In sum, bargains galore, but only for cash allocated to generate income, not near term living expenses. Long positions remain more at risk of declining before they appreciate, at least until credit issues appear to be healing. New long positions could also let you catch a multi day or week rally and, for the traders among you, a chance for a quick 10% or more profit taking.
- A Summary of Recent Events
If you haven’t been following the market, here’s the essence of what’s happened since the ten-year lows of late November. There’s a decelerating downtrend that may or may not signal a bottoming.
- The Good: So Much Wonderful Gloom
Ironically, the best news is the overwhelmingly bearish sentiment. This is bullish, since it suggests there’s lots of pent-up buying cash to provide the fuel to power the market higher.
- The Bad
In my December article, Top Energy Infrastructure MLPs…” (see “The Islamic-Russian Wildcard Bonus?” in my December article "Top Energy Infrastructure MLPs..."), I briefly discussed how Islamic terror and its sponsors could be depended on to provide a degree of support to energy stock prices by posing both long and short term risk to energy supplies. They continue to deliver faithfully on this threat.
In early February, Iran launched its first satellite. This means that Iranian nukes are no longer just Israel’s problem (surprise!). If Iran has a rocket powerful enough to heave a satellite into space, that same rocket can also toss a nuke into Europe, possibly beyond. For more on the ramifications, (all bad except for energy prices and for energy suppliers located outside the Middle East) for the West and its energy supply line, see Craig Karpel’s excellent article Iran's Strategic Nuclear Deception.
The Ayatollahs are rather “old school” about how one conveys strength, and (correctly) view Obama’s desire for “dialogue” as weakness, not strength. This is dangerous. The last time the Mullahs saw the U.S. President to be a wimp, (the failed Jimmy Carter) they took full advantage of him to expand their own influence and to humiliate the U.S. They won’t be any better with nuclear missiles, and can be expected to do all they can to threaten Western energy supplies.
- The Ugly
The market revisits November lows. At best it’s part of the bottoming process, or setting the stage for a near term rally. However, it could signal the next stage down. In the context of an established down trend, that’s how you bet until the evidence says otherwise.
Unfortunately, the evidence suggests more downside. As Tobin Smith recently pointed out, share prices in previous market crashes did not hit bottom until traditional valuation metrics like dividend yields and P/E ratios reached oversold extremes. According to these, the S&P 500 Index (i.e. the overall U.S. stock market) is still 20% to 40% above “market-bottom-capitulation” extremely oversold prices. Here’s why:
- Dividend Yields: While at a multi-year high of 3.5%, are still only 25% - 50% of the levels hit during the major crashes of the Great Depression, World War II, and the 1970s.
- P/E Ratios: The Price to Earnings Ratio represents the multiple investors are willing to pay for a dollar of earnings. Historically it sinks to 10 to 12 times earnings or lower before the market begins a sustained uptrend. Per Standard and Poor's estimates, it was over 16 times earnings in Q4 of 2008, will be over 14 times in Q1 of 2009, and could get as high as 18 times earnings by year end. Though the S&P 500 Index is around a ten year low, earnings in 1997 were 25% higher than those forecast for 2009.
Thus, it’s quite possible that stocks are yet due for a further drop of 20% or more.
Of course, that drop won’t be permanent, and will be difficult to time, as will the recovery. Meanwhile, U.S. treasury securities and the like pay us virtually nothing and provide no hedge against inflation or a weakening of the dollar.
Thus, those of us needing to generate income need to consider taking at least partial positions in high dividend stocks.
C. Ramifications for High Dividend Stock Investors
In sum, we’re still in a near term trading range, with the overall trend continuing down. Continue to invest only with funds allocated for longer term investment that you don’t need for the next six to eighteen months at least. What you buy now may well go lower.
- Consider a Partial Hedge with Selected Ultrashort ETFs
In addition to collecting high yields, those seeking a more active hedge may wish to consider taking measured positions in some of the Ultrashort Proshares ETFs as a partial hedge. For the unfamiliar, these are ETFs that move at twice the inverse of a selected sector of stocks. Thus, for example, if the S&P 500 index falls 1%, then SDS, its Ultrashort ETF, will rise by 2% (and vice versa). By nature these are volatile, so unless you like technical analysis and market timing, try to buy these only as a partial hedge at strong support when the market has just stopped feeling very optimistic, as a rally begins to show signs of fading. I’ll discuss these in detail in the near future, and compare them to other means of hedging to protect your principle. For now, however, consider taking partial positions in the following.
- UltraShort S & P 500 Proshares - Buy under $75, Strong Buy under $65
- UltraShort Financials ProShares - Buy Under $141; Strong Buy below $125
- UltraShort QQQ ProShares – Buy Under $55, Strong Buy under $50
- UltraShort Real Estate ProShares – Buy Under $58, Strong Buy under $48
- UltraShort Russell2000 ProShares – Buy Under $75, Strong Buy under $65
If you look at a chart for these, you’ll note my buys are very conservatively low. There is a lot of cash on the sidelines now, earning virtually nothing. Big players and insiders continue buying stocks we’ve been mentioning, because they’re clearly cheap and excellent long term values. As the past few months have shown, any glimmer of positive news brings buyers as everyone is waiting for the sign to jump in. Lots of cash on the sidelines will provide lots of fuel in the tanks for a rally.
If that happens, these ultrashorts can plummet fast, so you only want to buy them at strong support, so that if these levels don’t hold up you’ll know quickly and can get out before taking a big loss.
Thus, place sell stops no more than 10% below the Strong Buy levels to protect your capital. There are other Ultrashorts for other sectors, like the Ultrashort Oil and Gas DUG for shorting oil and gas. This one has been popular, but energy seems far closer to a bottom than a top, so avoid this one.
- Continue to Take Partial Positions at Our Recommended Strong Support Levels
Beyond the Ultrashort ETFs, if you can earn reliable dividends from 8-12 percent or more while you wait for recovery, ongoing investment makes sense. You just need to find the best bargain priced quality high yield stocks, and collect your income while waiting for the market to improve and offer additional options. As noted above, with a confirmed downtrend and good evidence for a further 20% overall drop, refer to our below recommended buy levels, which are at strong support levels.
- Use Sell Stops?
While our emphasis is buy and hold as long as the distribution is safe and fundamentals hold steady, some may want to hedge their bets, especially if they may need the cash within the next year or so. Those in that position should consider using sell stops around 15% below the Strong Buy price as partial principle protection, though you risk getting knocked out of your positions, only to see them come back soon and possibly rise higher while you miss the dividend. It’s a judgment call, though not a bad one, for at least some of your holdings given the current pessimism (which of course can change fast).
Again, our focus is on getting high yields from healthy businesses whose price will recover while we earn outsized returns, and we don’t try to time the market too much.
In this article, I begin a brief series on high dividend stocks that also protect us against a weakening U.S. dollar, and possibly weakening currencies in general.
Now let’s briefly consider the case for and against the U.S. dollar, as well as what might replace it.
THE CASE FOR AND AGAINST THE US DOLLAR
There is a consensus in the investment community that the U.S. dollar is in trouble. While there’s a lot you can read on the topic, here are two excellent, provocative articles from my fellow seeking alpha contributors: What's Going to Replace the Dollar? and U.S. Debt Default, Dollar Collapse Altogether Likely.
High dividend stocks that are denominated in USD are liquid assets, i.e. a form of cash, and thus vulnerable to declining in value along with the dollar. Thus, we high yield stock investors have a problem.
Or do we?
Please note, I make no claim to be an expert in macroeconomics, monetary policy, banking, or whatever specific field claims relevant expertise about the future of the dollar. But here’s a basic summary of opinion.
- The Case for the U.S. Dollar’s Demise
In essence, here’s why so many believe the U.S. Dollar (and dollar-based liquid assets like stocks and bonds) is in a long term decline.
It’s clear that the U.S. Government is planning to print a lot more dollars in order to revive its banking system and its economy. Basic economic theory says that when more dollars start chasing the same amount of goods, the dollars are worth less, as is everything priced in dollars, government and corporate bonds, U.S. manufactured goods and services, real estate, businesses, etc.
Unprecedented growth in money supply suggests unprecedented inflation is on the way, so liquid assets in U.S. dollars will be worth less. Like most world currencies, the USD is fiat money; it hasn’t represented a set amount of gold since Nixon ended the Gold Standard in the 1970s. It has no intrinsic value, only society’s confidence in it as a store of value. Once inflation becomes expected and confidence in the dollar wavers, restoring faith in the dollar and slowing inflation becomes increasingly hard.
FYI, many often go on to conclude the dollar will lose its status as the currency of last resort. The rest of the world will stop buying U.S. Government bonds, the U.S. goes bankrupt, world chaos, etc.
Conclusion, Disclosure & More Info
In this Part I, we’ve reviewed the state of the current market, its ramifications for U.S. dollar based high dividend stock investors, and a brief summary of the case against the U.S. Dollar.
In Part II we’ll:
- Review the case FOR the USD
- Criteria for high yield stocks that also provide a hedge against the U.S. Dollar
- Begin to look at some of the best stocks for combined high yield and USD hedge
Disclosure: I have positions in most of the above mentioned investments.