The recent downturn in both economic prospects and stock prices, as well as the Fed's commitment to hold interest rates low, along with the sharp decline in yields on Treasuries calls for another look at some of the sectors that have previously been discussed in this series. The big changes are that we have greater confidence that interest rates on Treasuries will stay low, we have considerably lower expectations of growth in the US and World economies, we are likely to have some degree of fiscal restraint, and we have a risk that Europe will blow up.
Some of these developments should make pieces of paper which produce reliable dividend yield even more valuable as investors find it harder and harder to squeeze yield out of their portfolios. However, there are two big negatives.
One is that some of the companies analyzed in this series will experience lower earnings and maybe even losses and it is not entirely possible that some of them will have to dilute shareholder value through secondary offerings. It is conceivable that some companies discussed in this series will experience severe financial distress. It is certainly possible that some of them will reduce or even cease paying dividends.
The second negative is that, no matter how strong some of these companies are, investors with margin accounts and mutual funds overwhelmed with redemptions will have to unload the shares leading to a meltdown in share price.
I think that it is very important to distinguish these two issues. The first issue is a fundamental issue and goes to the value of some of these stocks. It is important to analyze this issue and try to determine a reasonable valuation based on the new economic circumstances that are unfolding. The second issue is a market sentiment issue and can actually create opportunities to buy securities at prices considerably lower than fair value. The second issue is an example of what is sometimes called "Mr. Market" and is often identified as a source of opportunities to acquire stocks at bargain prices.
Looking at the big picture, I think it is becoming more and more clear that the "debt" issue is primarily a eurozone crisis. This is not because the United States and Japan have been more fiscally responsible. In point of fact, Japan is the worldwide debt champion with the highest ratio of debt to GDP. The United States has talked a good game about austerity but there really hasn't been much cut from the budget and the government is still spending a lot more than it is collecting. Yet, somehow, Japan and the United States pay very low interest rates.
Japan and the United States do not pay low interest rates because the market "thinks" that the governments of Japan and the United States will raise taxes and lower expenditures to the extent necessary to "pay off" the debt. Instead, the low interest rates are a product of the role their respective Central Banks play in the internal sovereign debt market. Essentially, the Central Bank sets a target interest rate and announces it. Because the Central Bank can print limitless amounts of money, it is clear that the Central Bank can buy enough sovereign debt to drive interest rates to whatever level it desires and the market quickly adjusts to this reality.
The eurozone improvidently eschewed this arrangement and so its sovereigns must negotiate the shoals, rocks, tides, and tsunamis of the bond market on their own - much like state and local governments in the United States. Why the eurozone followed obviously benighted advice and adopted a defective structure designed to produce procyclical forces which virtually guarantee its demise is beyond me. The result is that the zone as a whole pays much higher interest rates than it really has to and that its sovereigns must "convince" the bond market that they will balance their budgets by raising taxes and cutting spending at the very time that fiscal stimulus is most necessary.
This is an economic "Doomsday" machine that will lead the zone to implode with a resounding explosion unless things are restructured. As a perpetual optimist whose ancestors came from the part of Europe which produced Charlemagne, I tend to believe they will restructure to become more like the United States and Japan. But I am painfully aware that I could be very, very wrong.
So, in the short term, almost anything can happen. In the long term, many of the stocks discussed in this series have strictly domestic operations and are less subject to being infected with the bacillus of eurozone collapse. Some are particularly well positioned to ride this thing out. Others may experience some headwinds if the eurozone drives itself over the cliff while its respective members are arguing over whose turn it is to steer.
- Utilities - I have recently written a piece on electric utilities. They have almost exclusively US operations, as a group they increased dividends virtually every quarter through the 2008-09 Panic, they benefit enormously in a low interest rate environment and they are, in many cases, protected from competition. A famous historian wrote as WW1 broke out that "the lights are going out all over Europe." The lights will not go out in the United States. I like Exelon (EXC), Dominion Resources (D), Consolidated Edison (ED), Pepco (POM) and Duke (DUK).
- Agency Mortgage REITs - Earlier this year, the major concern with this sector was how it would perform when interest rates went up. You don't hear much about that any more. The high leverage these companies employ does create risks (there is no free lunch - you are not getting these double digit yields for nothing). I like Annaly (NLY) and Hatteras (HTS).
- Telcom - Again, these companies are almost exclusively domestic. I am nervous about the decline in landline service and, therefore, I would stick with Verizon (VZ) and AT&T (T) because they are less and less dependent on landline revenue due to their strong cellular positions as well as their broadband product lines.
- Tobacco Stocks - My article on this topic drew the largest number of comments on the morality issue. I will duck that one here. But let me make the point that companies which sell addictive products have an inherent advantage when the economy turns sour. I don't smoke and I am frankly a bit ambivalent about antismoking regulations but that is not the topic here. As investments at a time like this, I like this sector - especially Phillip Morris International (PM) (no matter how bad things get over there, the Europeans won't give up smoking at a time like this) and Altria (MO).