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I am bullish on dividend stocks, including the Wisdom Tree Equity Income Fund (NYSEARCA:DHS). What would change my mind? A recession that forces firms to cut dividends.

The cuts would first appear at the weakest companies: economically sensitive firms with poor dividend fundamentals. These stocks will be the canaries in the coal mine, and a red flag for dividend investors. So while I'm still bullish, I'm getting out when the dividend canaries start to sing.

The worst investments I've ever made all seemed like good ideas at the time. I guess we can all say that, so I make it a habit to consider how my assumptions might be wrong, or how the market might turn against me. But before I consider how my bet on dividend stocks could fail, let me first review why I believe it will succeed.

Macro Assumptions

  • Economy: We are stuck in a slow growth, low yield world. As we muddle our way through, there will be downside shocks to the system. These may tip the economy into recession, though this is not my baseline assumption.
  • Inflation: I believe inflation will emerge with a vengeance when the Treasury bubble eventually bursts, though I can't say when. (When does a rubber band break?) In the meantime, dividend stocks offer an attractive source of income, especially compared to bonds, which are hurt by inflation. Corporate dividends are driven by growth in revenues and profits, and companies that have pricing power will be able to pass on rising costs to their customers. Fortunately, dividends that rise over time represent compound interest for shareholders, and provide a hedge against inflation.
  • Company Profile: Given these assumptions, the best candidates are firms with strong finances, moderate payout ratios, a history of dividend increases, and a stable earnings outlook. The firms should also be concentrated in defensive sectors of the economy. A good example of this is the Wisdom Tree Equity Income Fund: It is overweight healthcare, consumer staples, and utilities, and it is underweight bank stocks. I am long DHS, and the fact sheet is here.

These reasons help explain why dividend stocks have been popular for years on Seeking Alpha, and why these stocks are now becoming popular on Wall Street as well. My assumptions don't reflect any special insight on my part. In fact, my rationale pretty much reflects conventional wisdom. Although there are many ways my assumptions could be wrong, most of these are market risks (recession, inflation, sector bets, geographic exposures, etc.). For dividend stocks, I believe the biggest risk is simply dividend cuts.

Dividend Cuts

Any dividend investor must routinely monitor holdings for developments that might lead to a dividend cut, or even a disappointment (such as a postponed increase by a Dividend Aristocrat). The typical warning signs are shortfall in profits, a rise in debt, a rise in the payout ratio, or a dividend cut by a company in the same industry. In most markets, these signals typically provide sufficient warning. Unfortunately, these aren't typical markets.

A Popular Investment

Fund flows into dividend ETFs are skyrocketing: In December 2011, Pershing Securities reported a 50% rise YTD. In addition to the reasons noted above, the Fed has flooded the market with liquidity via ZIRP and QE. This has driven up asset prices across the board, especially for fixed-income assets. So not only have dividend stocks become more attractive, but other alternatives for income have become less attractive (especially if inflation picks up). Consider the dynamics:

  • Fed purchases of U.S. government bonds have reduced yields and increased risk.
  • Funds have flowed into other fixed income assets (corporates and emerging markets), reducing their attractiveness. These also lack inflation protection.
  • TIPs have inflation protection, but are very richly valued.
  • REITs and MLPs are attractive, but are not for everyone. In addition, these markets are small relative to the bond market, and cannot absorb significant amounts of global capital.

Consequently, I believe that fixed income investors have shifted into dividend stocks, giving a boost to the entire asset class.

Extra Precautions

The continued popularity and the favorable climate for dividend stocks creates the risk that they will become overvalued. I'm not saying we are in a dividend bubble. But I am saying that investors need to be especially cautious about dividend stocks during this market cycle.

I noted above the typical warning signs of dividend cuts (high payout ratios, falling earnings, etc.). During the current market cycle, investors need to pay particular attention to these signals, and to economic sensitivity of the company: Is the dividend vulnerable to a recession? Investors should should not dismiss early warning signs from "weak" companies. These stocks invariably mark turning points in bull markets: The weakest tech firms fell in March of 2000 and the weakest homebuilding stocks fell in August of 2006. The weakest firms are always the canaries in the coal mine.

Where will the first cracks appear in the dividend foundation? The first dividend cuts are likely to appear in financially strapped companies in an economically sensitive industry. The consumer discretionary sector is a likely candidate. Thus, I could screen the consumer discretionary sector for dividend payers that have high payout ratios. These stocks would be first on my list of canaries, followed by dividend weaklings in other cyclical industries. I leave it to the quants to come up with a complete list of "dividend canaries."

How would this play out in the market? Here is how I envision the sequence of events:

  1. The economy deteriorates.
  2. Cyclically sensitive industries suffer.
  3. A few dividend canaries begin to sing: The weakest firms in the most cyclical sectors are forced to cut dividends.
  4. Initially, investors ignore the signal, since these are "weak" companies. Investors reason that "safe" companies won't be affected.
  5. This is correct at first, and investors rotate into "safe" dividend stocks (the bluest of the blue chips).
  6. The recession drags on.
  7. Other dividend canaries join the song: Dividend payers with strong finances begin to crack, and either cut dividends or postpone increases.
  8. Now comes contagion: The premium for dividend stocks erodes throughout the equity market. All dividends are now considered at risk, and dividend stocks drop 5% to 10% over a few weeks.
  9. Next, fund flows accelerate as hedge funds unwind their leveraged positions. It turns out that dozens of hedge funds have had a "dividend carry," since they bought dividend stocks with cheap, short-term debt.
  10. Interest rates creep up, which puts more pressure on hedge funds. Higher rates also make cash and fixed income more attractive, leading to capital flight from dividend stocks.
  11. The contagion winds down, leaving dividend stocks down 15% to 20% from their peak, and wiping out years of dividends.

This situation is hypothetical, and is not my base case assumption. But the risk is subtle: You lose money gradually, and you're tempted to ride it out. Then the situation worsens, and soon it's too late to sell. Fortunately, this risk is easy to avoid, since it plays out slowly, and the fundamental signals are easy to see.

Sell or Hedge?

Assuming that I see the warning signs, how will I reduce my exposure? For me, the decision to sell or to hedge depends on the client's goals and on the market signals.

Obviously, if I expect a weak economy to hurt stocks, I'll cut my weighting in equities, including dividend stocks. But I wouldn't sell if the recession appears shallow and short-lived, or if the market signal is ambiguous. I might just choose to live with the uncertainty, and partially hedge the position.

My options for hedging include buying put options on a stock, a dividend ETF, or on a broad equity index. Alternatively, I could buy an asset that is negatively correlated with dividend stocks, such as the VIX or an inverse leveraged ETF. (There are very few true hedges these days, since correlations converge during a crisis. But that's a story for another day.)

My thanks to Ed Stavetski of PCM Partners for allowing me to share his insights.

Disclaimer

Source: A Dividend Bull Considers How A Recession Might Play Out