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MARKET STATUS

Before continuing to examine the case for the U.S. Dollar and how high yield stock investors can hedge it while getting high yields, we first must look at the overall market, since almost all stocks follow the major indices.

  1. Still Down

In sum, as anticipated in my last article, the S&P 500 continues making lower highs and lower lows, now cracking 10 year support to hit 12 year lows.

The big near term question is, are we at the bottom of the past four months' trading range (if so, a good time to go bargain hunting), or at the brink of another decline? Given that we’re at the bottom of a four month trading range, any substantive positive news, especially about stabilizing the banks and credit availability, could spark a rally. Increased pessimism about the banks will bring the opposite. Mixed signals on the financial system will most likely mean we stay in the recent trading range.

  1. 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. The downtrend continues to break support to 12 year lows.

  1. The Good: Bearish Can Be Bullish

As mentioned in Part I, the overwhelmingly bearish sentiment can be bullish, since it lots of pent-up buying cash waiting to buy. It provides the fuel to power the market higher.

Here’s how it’s supposed to work, at least in the short term:

  • Buying begins with bargain hunters or positive news
  • Prices trend up
  • Short sellers begin to buy back stock to protect profits
  • Prices rise more
  • Afraid to miss the low prices at the start of a possible rally, investors sitting with lots of cash begin buying
  • More short sellers cover
  • Prices rise more, etc.
  1. The Bad
  • Stimulus and Banking plans fail to impress
  • Credit situation thus worsening, and that’s the core problem driving the market down
  • Support at 10 year lows cracks, hello 12 year lows
  1. The Ugly

If “The Bad” wasn’t ugly enough, as noted in my prior article, share prices in previous market crashes did not hit bottom until traditional valuation metrics like dividend yields and P/E ratios reached even further oversold extremes. Specifically:

  • 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, statistics support the prevailing sentiment that the market is still in freefall. 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.

  1. THE CASE FOR AND AGAINST THE US DOLLAR-CONTINUED

Last time we looked at the basic case against the U.S. Dollar. Here’s a basic look at the other side of the argument.

  1. The Case for the U.S. Dollar’s Survival as We Know It

Before you rush out to buy guns, preserved food, and gold to prepare for The End, take a few deep breaths and consider the arguments offered in favor of the dollar surviving in its same basic form and primacy.

  1. The Mother of All “Too Big to Fail”: Too Many Powers with Too Much At Stake to Let the USD Collapse

First, there’s the U.S. Government and its Citizens. Obviously, a society can’t function without a currency. Thus the dollar is, ultimately, a national security issue. Folks get mighty serious about that. In the past, the U.S. government has imposed a variety of heavy handed controls to keep its currency stable, including wage and price controls, banning precious metal ownership, closing banks and financial markets, pressuring allies, etc. In many ways, Obama & Co. are only limited by their imagination. The judiciary can be quite flexible in its interpretation of law and the Constitution in times of emergency.

Since everyone in the U.S. will suffer from a dollar collapse, the Obama administration will have the political support to do what it takes to preserve its currency.

Next, there’s the rest of the world.

  • They Own lots of U.S. Dollars. Since WWII left the U.S. as the undisputed leading economic power, most of the world’s liquid wealth is tied to U.S. dollars in some way. Except for a few die hard opponents of the U.S. no one wants the dollar to die, because every government and economic entity of size holds a great deal of dollar denominated assets. What happens if those assets seriously devalue?
  • They Export to the U.S. Next, consider the other major economic powers and how they’d fair with drastically reduced exports to the U.S. Can the rest of the world fill the void in demand if the U.S. market seriously shrinks from a crippled dollar? Do they want to?
  • Your Currency or Mine? They Need an International Currency: It makes life easier, and replacing the dollar will create its own set of, ahem, issues and disagreements.
  1. Will the USD Remain Currency of Last Resort? Does Anyone Have a Viable Alternative Existing Currency?

A story: Their aircraft suffering from engine failure, Smith and Jones are forced to parachute into the African Savannah. They notice a lone lion approaching them with a hungry look. Smith begins to run. Jones yells out to Smith “You can’t outrun a lion.” Smith yells back “I don’t have to outrun the lion, just you.”

The point is, every economic block on the planet is also hoping to inflate their way out of trouble. Exchange rates are relative. Thus the dollar can remain predominant simply by being seen as the best existing currency, even if all are in trouble. Remember the mid 1970s and early 80s, when inflation was so high you could get bank CDs around 15%? The dollar retained its status.

True, conditions aren’t the same, but the point is that inflation alone does not mean the end of the dollar. Relative status of currencies depends on a variety of factors, particularly the health of the underlying economy relative to that of others. The Chinese economy may be growing better, but they link their currency to the USD to keep their exports relatively cheap. Unclear if they’ll change that policy any time soon. What is clear is that they also hold a massive hoard of dollar investments and would suffer along with the dollar.

  1. Other Ideas?

Unless I’ve badly missed something, I don’t know of any obvious substitute for the U.S. dollar, for a variety of reasons. You’ll find some very creative ideas in Paco Ahlgren’s excellent What's Going to Replace the Dollar?, but I doubt you’ll see any convincing substitute. In the end, he humbly admits we need some kind of liquid currency and leaves with a few creative but unconvincing alternatives. So, he advises us to be in anything but dollars. But with what will you buy those assets? What will your seller accept? One alternative he suggests is privately issued currencies backed by gold, silver or something else. I believe such things have existed in before the advent of strong central banks.

While the idea is conceivable, questions and problems abound. Whoever tries to set up “Joe’s Currency Inc,” “McDollars,” and the like will need access to an awful lot of precious metals or other universally recognized hard asset if the Chinese, Saudis, or any central bank shows up at their exchange window. What then, does “Private Money Inc.” do with the dollars or other gutted currency they’re likely to get in exchange?

Is another one of the major currencies a viable substitute? Mr. Ahlgren doesn’t see one, and admits their supplies are also rapidly expanding. The Chinese economy is far healthier, and the major OPEC powers have lots of valuable oil and gas. However, do the Communist Chinese, the Saudi King, or the Ayatollahs have the credibility to gain the world’s trust?

I welcome anyone’s suggestions about alternatives to the dollar.

Nonetheless, prudence dictates that since high yield stocks tend to be dollar denominated, we income stock investors seek some alternatives that protect our income and principle against the risk of a declining dollar.

There are other dollar hedging alternatives to high dividend stocks that have dollar hedging characteristics I describe below. For example:

Foreign Exchange or Forex Trading: This is a form of trading, not investing. However for those with the expertise, it’s an idea. It’s can be a currency hedge, but there’s not steady income from dividends and like any form of trading, you can lose heavily if you’re not a skilled trader.

Buying Foreign Currency Denominated CDs or Bonds: Also an idea, though the risk-reward ratio is better with the stocks mentioned below, which I’ll discuss in greater detail in the coming weeks.

  1. WHAT MAKES A HIGH YIELD STOCK “USD-COLLAPSE-RESISTANT”?

Because most investors still need to hold liquid assets that produce high passive liquid income, here are three key criteria for selecting stocks that provide both high yields and a hedge against a weakening U.S. Dollar.

Outstanding Business: Before anything, the underlying business should be robust. So as always, the first criterion is great fundamentals and reliable revenue streams that can support and grow distributions, even in recessions.

Based in Hard Assets or a Monopoly-Like Position in Vital Services:

There are a variety of such niches, but there are two basic types.

  • The business owns, sells, or otherwise profits from assets with strong intrinsic demand that allows enough pricing power for revenues to keep pace with or exceed inflation. This includes firms tied to energy, vital agricultural or industrial commodities, precious metals, water, etc. While many commodities and currencies related to them are down, it’s a temporary condition to be exploited, not feared. The underlying long term demand for the above commodities is growing along with the populations and economies of China, India, and others.
  • Alternatively, a provider of critical services that for some reason dominates its market, like a major well run utility or dominant communications company.

Non-USD Denominated: Shares and/or distributions are priced in another currency, ideally a commodity based currency like Canadian or Australian dollars, but any other major currency would provide some hedge. We can include here U.S. dollar denominated and U.S. firms that get the majority of their earnings in other currencies. Beware, however, that the foreign exchange markets are notoriously hard to predict and at given time the dollar could strengthen against your alternative currency. Thus the foreign currency can become a liability. But if you’re already overloaded in USD, then some hedge in another currency makes sense, especially hard asset based currencies.

In short, we’re seeking stocks of strong companies that mostly earn and distribute a high dividend in a non-USD currency and have a dominant position in a market for an essential product or service.

  1. Conclusion, Disclosure & More Info

In Part II we’ve reviewed the current market, the case for the USD, and the key criteria that make a high dividend stock a USD hedge.

In Part III, we’ll begin looking at specific sectors and recommendations that fit these criteria. The coming articles will examine individual categories and stocks in greater detail.

Disclosure: I have positions in most of the above mentioned investments.

Continue to Part III >>

Source: The High Dividend Stock Investor's Collapsing Dollar Survival Guide, Part 2