As I have repeatedly said here, deflation is spreading worldwide as more central banks embrace negative interest rates, and then push rates lower. Last Tuesday, Japan’s 10-year bond yield fell below 0% and no one knows just how much farther negative interest rates may plunge. Last Thursday, Sweden’s Riksbank lowered its key interest rate to -0.5% from -0.35%. Even more disturbing, last week’s sell-off in major French and German banks was an ominous sign that Europe’s credit problems are not limited to Italy.
The signs of deflation are everywhere: Crude oil hit a 13-year low last week before staging a big short-covering rally on Friday. On Tuesday the International Energy Agency warned that Iranian and Saudi Arabian crude oil output is higher than expected. Coming on top of the global crude oil supply glut, this makes it likely that crude oil prices will remain soft. On Thursday The Wall Street Journal (in the “Heard on the Street” column) revealed that the Cushing, Oklahoma storage facilities were near capacity. That spooked the stock market, with the S&P 500 touching an intraday low of 1810 before recovering to 1865 Friday.
On Wednesday, Fed Chair Janet Yellen appeared before the House of Representatives and signaled that the Fed is monitoring the growing risks to the U.S. economy. Specifically, Yellen said that financial conditions “have become less supportive to growth,” but added that the U.S. economy should continue to expand. When Yellen said, “monetary policy is by no means on a preset course,” she effectively implied that the Fed will not raise key interest rates anytime soon. Furthermore, Yellen admitted that inflation remains suppressed, which means that the Fed does not have to raise rates to fight any mythical inflation.
When questioned about negative rates, Yellen implied that the Fed is not ready to implement negative rates, due partially to the fact that it may not be legal in the U.S. On Thursday before the Senate, Yellen implied that the Fed was not responsible for the stock market’s recent woes and stressed that monitoring the stock market was “not mainly our policy,” but she also admitted that the stock market may impact the economy. Overall, she was very dovish, implying that the Fed would most likely to do nothing in March.
On Thursday, Japan and Europe sold off sharply and that selling pressure carried over into the U.S. markets. The major energy and money center banks that led the market sell-off are effectively falling into the “black hole” that deflation created. There is no doubt that black holes are scary, especially when they spread into more industries, like major money center banks.
However, since the S&P 500 yields more than the 10-year Treasury bond, which is now at the lowest level since 2012, the stock market should bounce soon. I am looking for stocks characterized by buy-backs and dividend growth – which exhibited relative strength during the big sell-off on Thursday – and I also recommend gold and Treasury securities.
The truth of the matter is that deflation cannot be solved by relentless money pumping and negative interest rates, so central banks are effectively out of tools to fix the problem. As fears of negative interest rates spread, deflation continues to spread to more asset classes. Now that deflation has spread from commodity-related companies to financial stocks, how many other sectors can deflation encompass?
We are now at a record divergence between the S&P 500’s dividend yield and the 10-year Treasury bond yield. The S&P 500 now has a 2.33% annual dividend yield, while the 10-year Treasury bond yields only 1.74%, for a spread of 59 basis points. Historically, whenever the S&P 500’s annual dividend yield is more than 50 bps higher than the 10-year Treasury bond yield, it has sparked a big rally in the S&P 500.
Last Tuesday (in “S&P 500 Dividend Yield vs. 10-Year Treasury Yield”), Bespoke Investment Group studied every time in the last 50 years that the S&P 500 dividend yield has topped the Treasury yield by 50 basis points or more. It has happened three times, all recently, with significant market gains to follow.
On Friday, Bespoke added (in “Thirty-Year Yield vs. S&P Dividend Yield,” February 12, 2016): “In yesterday’s intraday Treasury rally, we saw something even more uncommon occur where the yield on the 30-year U.S. Treasury briefly dropped below the dividend yield on the S&P 500,” adding this:
…going back to 1977 (when data on the 30-year begins), the only other time that the S&P 500 yielded more than the 30-year was in the depths of the financial crisis from November 2008 through March 2009! When you get a situation where investors are willing to accept less in coupon from a security that offers no upside if held for the next 30 years than the S&P 500 over that same time period, it says that either sentiment is very negative, investors expect long-term equity returns to be severely depressed, and/or future dividends to be lower than they are now.
A third Bespoke analysis I want to quote is “2016: High P/E Slaughtered” (February 9). Writing on a day when the S&P was down 10.5% year-to-date, Bespoke analyzed the 10 market deciles (from the top 10% to bottom 10%) in various criteria in the first 40 days of 2016. Here is a summary of their findings:
All of a sudden in recent weeks, investors have become laser focused on valuations, and if you have an above-market valuation, you’re getting sold. Stocks with the highest dividend yields are down but not down nearly as much as stocks with very low or no dividend yields. Notably, the decline of stocks most loved by analysts at the start of the year are down the most of any decline in the entire matrix at -16.5%. Stocks hated by analysts are doing much better. Stocks with little institutional ownership are outperforming as well, while the same is true for stocks with relatively low international revenue exposure…. Stocks with the highest P/E ratios have gotten absolutely crushed this year, with the highest P/E decile down 15.6% YTD.
Looking forward, I am watching high-dividend, low price-to-earnings stocks to see if bargain hunters want to acquire a monopolistic company at only seven times trailing earnings with over a 2% dividend yield. These types of stocks exhibited relative strength last week, so that is a good sign that they could lead a stock market rebound. I also noticed a lot of bargain hunting in small-cap stocks and international ADRs, so it seems like quality stocks may lead the next market rally.
In the meantime, stocks with high price-to-earnings ratios remained under relentless selling pressure. I remain worried about high-dividend stocks over the longer term due to the fact that 2016 is shaping up to be a record year for dividend cuts, but near-term many dividend stocks are exhibiting relative strength.
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