Doom or boom? That’s the question many investors are asking as we enter a new year. Will we see many happy returns, as we did in 2009, or will 2010 be another year when the markets roll over and play dead?
Judging from reader mail, tops on the list of worries for this year are taxes. To date, the Obama administration and the Democrats in Congress have done relatively little on this front. In fact, tax rates are still right where they were when President Bush left the White House.
One likely reason for inaction so far is the weakness of the overall economy and the fear that raising taxes now will kill off growth. But given the combination of record federal budget deficits and ambitious spending plans, higher taxes are only a matter of time, with high-income and high-net-worth individuals the primary targets.
Both houses of Congress have now passed health care legislation that includes new taxes. The negotiated bill is likely to be voted on in the next couple of weeks and will almost certainly contain new levies on a range of goods and services, including a higher Medicare “surcharge.”
The president and Congress have raised fears by proposing measures such as a complete rollback of income tax rates to pre-Bush administration levels, and even limiting deductibility of charitable contributions. Ironically, however, the worst result for investors may be if they do nothing. That’s because, despite holding big majorities in Congress and having a then-extremely popular president, Republicans attached a deadline to preferential investment tax rates of 2011.
As a result, unless Congress and the president act, the 15 percent top rate on dividends and long-term capital gains will vanish on Dec. 31, 2010. Common stock dividends at that point will be treated as ordinary income, with the rate for top earners rising to 39.6 percent.
I’ve urged readers several times to visit DefendMyDividend.org and sign the organization’s petition to extend the preferential rate on dividends. The good news is the president has proposed making a preferential tax rate on dividends permanent, with a tradeoff of raising the top rate to 20 percent. The 20 percent top rate plan, in turn, has been introduced by Senate Finance Committee Chairman Max Baucus (D-MT) in legislation as well.
In my view, the market has never fully priced in the 15 percent top tax rate on dividends because it was never conceived of as permanent. That should limit potential damage to dividend-paying stocks, should the preferential rate expire without action. Moreover, if preferential rates are made permanent--even at the cost of raising the top rate to 20 from 15 percent--the move will be priced in, and dividend-paying stocks could actually get a lift. But unless there’s action, the rates are going up.
Growth and Inflation
Investors also continue to be deeply vexed and perplexed by the economy. Many are worried that the impact of government stimulus is at best waning and at worst has been counterproductive toward lifting the US out of the doldrums. The result they fear will be a double-dip recession this year.
As my colleague Elliott Gue has pointed out in PF Weekly, double-dip recessions have thankfully been extremely rare throughout economic history, at least without a period of growth in between. Some, however, are worried that inflation and US dollar weakness will force the Federal Reserve to jack up interest rates before the economy has fully righted itself, sending us into another tailspin.
This is roughly what happened in the early 1980s, when then-Federal Reserve Chairman Paul Volcker sent interest rates massively higher and plunged the US economy into a deep hole. Volcker, however, faced a much different problem than does current Fed Chairman Ben Bernanke. Mainly, a decade-plus of accelerating inflation had hit a crescendo in double-digits. Pushing up rates dramatically was the surest way to kill it off, which in fact it did.
In contrast, Bernanke and the current Fed face no real inflation pressures now. Commodity prices remain volatile, and the US is no longer the only major market for such vital ones as oil. In fact, we’re not even the biggest global market anymore for a wide range of raw materials. China, for example, now consumes more than twice as much copper as we do.
Rising commodity prices were very much a part of 1970s inflation. But the wage-push inflation of that time is nowhere in sight. Nor is it likely to be anytime soon, with official unemployment over 10 percent nationwide and unofficial joblessness almost surely much higher.
In stark contrast to previous decades, job growth in the US was basically zero for the decade that ended last Friday. Wage growth was equally dismal. In stark contrast, US employment grew by 31 percent in the 1960s, 27 percent in the ’70s and even 20 percent in the ’80s, after Volcker’s harsh medicine had done its work.
There are, of course, many examples historically of economies suffering stagflation--i.e. a chronically weak economy and high inflation. And that may well be what we see eventually. It’s just not what we’re in now. And aside from rising commodity prices and some US dollar weakness, there are few signs of it.
My view is this is still a bifurcated market for income investors, just as it has been since the fall of Lehman Brothers (OTC:LEHMQ) in September 2008. On the one hand are Treasury bonds and the US dollar, which rally whenever the global economic news looks gloomy. On the other is virtually everything else with a yield, rallying on days when the economy seems to be improving and tumbling when the news sours.
Until the US economy is back on its feet, this is the environment we’re going to be in. Eventually, I think we’ll see more inflation, and quite possibly a lot of it. At that point, all income investments will revert to being interest rate sensitive, rather than economic growth sensitive. But until growth does pick up, it’s going to be very hard for that to happen.
Fighting the Fear
The threats of rising inflation, a double-dip recession and higher taxes are enough to get anybody down. And they’re far from the only potential catalysts for a stock market selloff in 2010, including of high-quality, high-yielding investments.
The mere fact that so many income investment types scored such stellar gains in 2009 is a worry in itself. There are still plenty of high yielders--from utility stocks to master limited partnerships (MLP)--that are cheap relative to the health and growth of their underlying businesses. But almost nothing worth its salt is as cheap as it was in March 2009. And explosive moves must always be digested by the market, even if much of their pop was simply a comeback from disaster.
As I pointed out in last week’s Utility & Income, politics are a constant threat to market health. Happily, at least thus far, rhetoric has run far ahead of real action. The leading health care and carbon regulation bills in Congress, for example, are backed by sizeable elements of the industries they’d regulate. It’s simply laughable to compare that kind of activity with, for example, the wholesale nationalization going on in Venezuela, or even with what we saw in the 1970s in this country.
Judging from the popular mood, however, almost anything the Obama administration does from here on in has the potential to set off a wave of investor emotion--mainly fear, loathing and selling. And that’s not even touching on potential global events, including acts of terrorism.
One thing investors need to keep in mind in the coming year is that bull markets always climb a wall of worry. A fearful market is almost always the least risky time to invest. In contrast, when investors get too far and happy, losing their caution, danger of big declines is always at its greatest.
Consequently, the fact that so many investors fear a repeat of late 2008 is probably the most bullish factor this market has going for it in early 2010. That doesn’t mean there aren’t going to be gut checks and even what appear to be mighty selloffs. In fact, judging from the selling on the last trading day of 2009, we could be in for one imminently. Huge institutions that control the market float were clearly playing defense going into the end of 2009 to lock in the gains of earlier in the year. And they’ve got plenty of reasons to stay cautious as 2010 begins.
Individual income investors, however, aren’t bound by the same constraints as those who run big money. There are no designated three-, six- or 12-month performance periods, which money managers’ compensation is based on. Rather, the goal is building wealth over time. Portfolio value on January 4 is just as important as what it was on December 31.
When the institutions bail out of the market, as they did in late 2008, nothing is spared. Similarly, when they return to the market, as they did in mid 2009, almost everything rebounds. If their timing is right, traders can do quite well moving in and out based on what institutions do.
Income investors, however, have got to stick around to collect dividends. Trading cuts into income because you miss payment dates and pay higher taxes and transaction costs. Moreover, as we saw under the extreme market and economic conditions of 2008-09, companies backed by strong businesses held their dividends. And their share prices bounced back when market conditions improved.
The best course for income investors over the past two years is precisely the one we recommended--that is sticking with positions as long as the underlying companies’ business numbers were steady, regardless of their ups and downs.
For example, holding onto Enterprise Products Partners LP (NYSE: EPD) wasn’t easy in late 2008 when it sunk to under $18 per unit, or even in March when it nearly revisited that level. But the MLP continued to expand its portfolio of energy infrastructure while raising its distribution every quarter like clockwork. As a result, the units are back where they were when the bear market began in mid-2007.
Sticking with positions in dividend-paying stocks backed by strong underlying businesses is still the best strategy for income investors coming into 2010. And we may indeed have another opportunity to buy early this year, should institutions temporarily trade out of the market.
As for dealing with the risks of inflation and taxes, three investment classes stand out: energy-focused MLPs, Canadian trusts, and foreign-based utilities.
MLPs pay distributions from pre-tax cash flow rather than dividends from post-tax earnings. As a result, investor taxes won’t be affected if the preferential 15 percent top rate on dividends goes away. The possible exceptions are MLPs such as AllianceBernstein (NYSE: AB) that rely on “carried interest” to minimize taxes. These have been targeted by a bill that has now passed the House of Representatives and enjoys broad support in Washington. They do not include energy MLPs.
A number of energy MLPs are also positioned to profit from higher energy prices, either by producing it or by relying on processing fees that depend to some extent on oil and gas prices. With no wage-push inflation anywhere in sight it’s inconceivable inflation can get off the ground without higher energy prices. That makes energy MLPs excellent hedges against both higher inflation and higher taxes.
Canadian trusts are also hedged against inflation because they pay distributions in Canadian dollars. The loonie, as it’s known to Canadians, is basically a petrocurrency, following the ups and downs of oil prices over the long term. Again, inflation over the next several years is virtually impossible without higher oil prices.
Consequently, if there is inflation, oil and the loonie will rise against the US dollar, lifting the US dollar value of trusts’ distributions as well as their unit prices. And the impact will be even greater for trusts that produce energy, as rising cash flows make it possible for them to grow faster and pay higher yields.
Unlike MLPs’ distributions, trusts’ distributions will be subject to a higher tax rate in the US if preferential tax rates on dividends disappear. And trusts also face a day of reckoning of sorts in Canada in 2011, as they convert to corporations and are forced to absorb corporate taxes.
On the other hand, there are some definite offsets. First, of the 25 trusts to convert to corporations thus far, nearly half pay the same dividend they did as trusts. Second, converting trusts are up an average of 30 to 35 percent from pre-conversion prices. The bad news of taxation has been priced in since it was first announced Halloween night 2006. Eliminating the uncertainty by converting was all it took to bring back the buyers, handing unitholders windfall gains.
Foreign utilities’ primary appeal is also that they’re priced in and pay dividends in foreign currency. Here, the best bets are in the growth economies of Latin America and Asia. Should inflation raise its ugly head, investors get the benefit of an appreciating currency. Also, inflation will only come with economic growth, which will be strongest in these economies.
There will still be the impact of US higher taxes on dividend income. But solid growth will go a long way to offset that. And foreign withholding taxes will still be reclaimable by filing a Form 1116 with your US taxes.
These certainly shouldn’t be the only investments you own. But added to a diversified mix that includes utilities, low-duration bond funds and even some low-risk real estate investment trusts and small banks, they’ll provide powerful protection from today’s threats. And they’ll provide peace of mind amid the even more dangerous fears that can lead to the greatest risk of all: basing investment decisions on emotion, rather than rational analysis.
Question of the Week
Here’s a frequently asked question submitted by readers. If you’d like your question answered, please write to email@example.com.
- How much credence should we give credit rating agencies like Standard & Poor’s, Moody’s and Fitch after the recent financial crisis? They sure missed it on the banks.
It’s probably the understatement of the 21st century that credit raters misjudged the risk to the financial system before the crash. Their biggest mistake, obviously, was underestimating the risks from mortgage-backed securities, for which at one time they were handing out AAA ratings on like candy.
Worse, this is hardly the first time they’ve completely missed the boat on a major industry meltdown. Back in 2001, for example, S&P rated Enron investment-grade the day that company filed for Chapter 11 bankruptcy. WorldCom also held high ratings right up until it wiped out its stockholders.
I also vividly remember an S&P conference I attended in the mid-1990s regarding utility deregulation. The analysts were adamant that massive construction of natural gas-fired power plants by independent power producers--combined with industry deregulation--was destined to make dinosaurs out of coal and nuclear power plants. And they forecast financial doom for the companies that owned them, unless they could recover the value of those plants on their books.
My question to the analysts at the time was how the forecast would change if natural gas prices budged out of what was then their price range of roughly $1 to $2 per million British thermal units. Their response was they didn’t forecast energy prices.
That information, however, would have been very helpful to anyone following their advice. Just a few years later, natural gas was well over $5 and the economics of gas plants had been turned on their ear. Independent power producers focused on gas were struggling to survive. Meanwhile, a handful of utilities, including Exelon Corp (NYSE: EXC) and Entergy Corp (NYSE: ETR), were thriving after purchasing nukes for pennies on the dollar.
I don’t say this to imply that credit raters are stupid, corrupt or don’t do their homework. In fact, I strongly believe the opposite. They are, however, just as subject to the prevailing market mood as any other analysts or research houses.
The first key to using credit-rater research effectively is simply recognizing that fact. Raters’ research is intensive and focused exclusively on credit dangers, which are also the primary risk to dividends. That’s a stark contrast to ordinary equity research, including S&P’s own equity research, which is often focused on pricing and growth issues that are less important to income seekers.
The best time to use rater research is when they’ll identify the most potential risks, which is generally when the market mood is worst. Rater research on utilities, for example, was entirely focused on the worst-case scenario in early 2003, when Enron’s collapse had pushed some two dozen companies to the brink of Chapter 11. Early 2003 proved to be a phenomenal time to buy utilities. And S&P credit research was very meticulous on highlighting the risk.
Credit-rater research has been generally dour on utilities ever since, with outlooks improving only slightly in recent years despite huge reductions of debt and operating risk. But again, so doing it actually held down risk by keeping investor expectations down. Also, because credit ratings affect companies’ cost of capital, skeptical raters have kept utility management focused on cutting risk for the past several years. And that was the biggest reason the group held together throughout the recession.
In contrast, the worst time to look at credit rater research is when an industry has been strong for a long time. Analysis is less skeptical, for one thing. For another, raters are paid by those they rate. Higher ratings mean a lower cost of capital for the client. Be skeptical.
Disclosure: no positions