Negative Rates Could Send S&P 500 To 925 If Not Eliminated

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Includes: AEP, D, DUK, EIX, EXC, NEE, PCG, PPL, SO, SRE, XLU
by: Michael Markowski

Summary

Shares of all utilities could decline by more than 50%.

History says that the bear, likely born May 2015, will bottom in Q4 2017 or Q1 2018.

Mark-downs of dividend paying stocks would kill negative rates.

Yen was key leading indicator for the 2008 crash.

Central banks eliminating NIRPs would prevent correction.

Unless the world's central banks take immediate action to rid the world of the insidious NIRPs and negative interest rates, the likely outcome will be that all of the world's income-producing assets will have to undergo significant markdowns. Should the yields of U.S. Treasury debt securities become negative, a meltdown of the global banking system and a crash of global markets might be inescapable. Should that happen the S&P 500 could potentially decline by more than 50% from its most recent 2,045 to 925. My calculation is based on what the S&P 500's dividend yield was on March 9, 2009. The yen's appreciation against all of the world's major currencies since the bank of Japan instituted its negative interest rate policy (NIRP) on January 31, 2016 is signaling that a crash of the world's markets could soon begin.

After observing the most volatility that I had seen in my 40 years in the markets in early 2016, I conducted research on the crash of 2008. This led to my developing the NIRP Crash Indicator, which is powered by metrics that could have been utilized to predict the crash of 2008 and its V-shaped reversal. Throughout the month of March, the NIRP Crash Indicator's signal remained a Cautionary Yellow. At the close of April 1, 2016 - the day the S&P 500 and Dow 30 closed at their highs for 2016 - the signal was elevated to Pre-Crash Orange. During the week ended April 8, volatility of the markets returned to February 2016 levels, with all of the major global market indices closing down by more than 1%. Following are reports that I have produced covering the negative rates crisis:

The best solution to stop the spreading of NIRPs and negative interest rates is for central banks of the world to immediately enact or redact policies to abolish them. This would be the catalyst for the yields of the sovereign securities of Japan and Germany becoming positive. In the absence of this happening, a possible remedy to fight the NIRP and negative interest rate contagion could be the resetting of valuations of all income-producing assets to a discount in the marketplace as compared to their most recent valuations. The decline in valuations of income-producing assets would result in a significant increase in their yields. The yields increasing to sufficient levels should motivate safe haven and other investors to liquidate their holdings in negative- and low-yielding sovereign debt securities to purchase the less secure and much higher-yielding income-producing assets. The availability of significantly higher yields on income-producing assets would, hopefully, discourage safe haven and other savvy investors from "being fearful", and encourage them to "become greedy".

With significant declines in the values of all less secured income-producing assets, and resultant increase in their yields, market forces would take over. The result would be that markets would drive down prices of treasuries and other sovereign debt securities, and their yields upward into substantial positive territory. Upon yields of the world's sovereign debt securities skyrocketing, the demand for and prices of negative and low interest rate securities will collapse. The need for central banks to utilize NIRPs will have been completely exhausted.

Case Study: American Electric Power versus 10-Year U.S. Treasury Note:

To prove my theory and validate my suggested remedy, I conducted research on the share price and dividend yield behavior of the public utility company, American Electric Power (NYSE: AEP), before and after the crash of 2008. I also focused my research on the price action and yields of 10-Year U.S. Treasury bonds over the same period. My focus was on a utility company because shares of a utility have always been considered the safest form of equity investments. If a utility bill is not paid, the electricity is turned off. For this reason, a utility's dividend payments are reliable. Thus, the dividends of a utility company are much more secure than are dividends of any non-utility company. During the Great Depression, AEP was able to maintain and increase cash dividends. For these reasons, it is assumed that the yield for shares owned of a utility will always be lower than the yield that one might expect to receive from shares they hold of a dividend-paying, non-utility company.

The shares of American Electric Power is a good example of a safe income-producing asset that could potentially motivate a holder of negative or extremely low interest rate sovereign securities to liquidate them to purchase its shares. With a current annual dividend of $2.24, and a most recent share price of $67.00, AEP has a yield of 3.39%. Based on how AEP's yield and share price behaved before and after the crash of 2008, an increase of its yield to 10% would likely be sufficient to motivate a holder of low or negative interest rate sovereign securities to buy its shares. A decline in AEP's shares by approximately $45, or by 66%, to a share price of $22 would increase its dividend yield to 10%. Should such a scenario unfold, it would be very similar to what happened to AEP's share price and yield before and after the crash of 2008. The chart below graphically illustrates the share price and dividend yields of AEP over the last 10 years.

On July 31, 2008, AEP's share price was $27.84, and its annual dividend yield was 5.9%. From the end of July 2008 to March 9, 2009 - the same date that the S&P 500 Index (the Index) bottomed - AEP's share price declined by almost $10 (or by 36%) to a 5-year low of $17.73 and to an equivalent dividend yield of 9.2%. Over the same period, the price of a 10-year U.S. Treasury note increased by 33%, and the yield fell from 4% to 3%. In June of 2009, three months after AEP's share price had bottomed, the price of AEP's shares had increased by 21% and its yield had fallen to 7.6%. Over the same three months, the price of the 10-year Treasury bond declined by 25% and its yield had gone back to the 4% from which it started a year earlier. Based on the opposite behavior of yields, the price action of AEP's shares, and the 10-year Treasury notes from July of 2008 through June of 2009, it is very likely that holders of the notes were selling them to purchase shares of AEP and other high-yielding utility companies. See CNBC's historical yields chart for 10-Year U.S. Treasury notes. My research confirms that holders of Treasuries and sovereign debt securities will sell them for less secure income-paying securities upon the yields increasing substantially.

On April 8, 2016, the dividend yield for the S&P 500 - based on its close of 2,045 - was 2.1%. Under the assumption that the dividend yield of the Index would have to increase to 4.7%, which was the S&P 500's yield when it hit bottom on March 9, 2009, the index would have to decline to 925 (based on its annual dividend rate of $43.00 on 12/31/15). The video below titled, "Why Negative Rates could send the S&P 500 to 925", covers the content of this article, including AEP and the S&P 500. It also provides the rationale as to why I believe the final solution to rid the world of negative rates would require a significant mark-down of most of the world's non-sovereign income producing assets.

There are two concerns or questions that I have about whether or not 925 will be the final bottom for the S&P 500 should a significant markdown of non-sovereign income producing assets occur. The first is that I doubt the yield of 4.7% will be high enough to coax safe-haven investors out of their sovereign bond bunkers. Had the Obama administration not injected massive and immediate fiscal stimulus into the economy as soon as the new President was inaugurated, the S&P 500 would have probably fallen to a much lower level. It speaks volumes that American Electric Power and other utility companies had dividends yielding in excess of 9% at the March 2009 market bottom. After all, why would any red-blooded, dividend-seeking investor want to hold shares in a non-utility company having a dividend yield that is at a 50% discount to a utility? My other concern, or question is, "Will the S&P 500 be able to maintain its dividend rate?" Uncertainty within the energy industry, and the resultant recent volatility in the price of oil will make this more difficult. Also, a sudden and significant decline for the S&P 500 to even near 1,000 would likely induce a U.S. recession. Because many of the world's economies are either in - or close to entering - a recession, a decline of the S&P to much lower than 925 could be the catalyst for the world entering its first economic depression since the 1930s. In 1930, a year after the crash of 1929, the S&P 500's dividend rate went to an all-time high. By 1935, the index's dividend declined by 44%. The S&P 500's dividend rate did not eclipse its 1930 high until 1955.

For the world's safe-haven investors to liquidate their sovereign debt holdings will likely require that the yields on less secure income-producing assets, including the dividend paying S&P 500 and utility companies, increase to at least 10%. The world is much more financially fragile in 2016 than it was in 2009. The debt of the U.S. has doubled since 2008 from $10 trillion to $20 trillion. The world's central banks have taken drastic actions to prop up their economies... to no avail. Until the negative interest rates are totally eliminated, investors will remain fearful. Based on my 40 years of experience, I predict that double-digit cash flow returns will be the minimum threshold required for savvy and conservative investors to no longer be fearful.

Assuming that all of the world's central banks that have instituted NIRPs do not repeal them, the issue would become how the resets of the world's income-producing equity and non-sovereign debt markets - required to exterminate the NIRPs and negative interest rates - might take form? Will it be a swift crash, or a gradual correction? Based on my experience, it is not likely that the markdown will be from a cliff-dive. The correction would most likely occur with valuations of the markets ratcheting downward in stages. Markets would not likely bottom until late 2017, or early 2018 for two reasons, as follows:

  • A correction of more than 40% from a market's all-time high to its trough has historically taken time. There have been five such corrections over the last 100 years, as follows: 1919 to 1921, 1929 to 1932, 1973 to 1974, 2000 to 2002, and 2007 to 2009. (The four corrections, prior to the one ending in 2009, lasted at least 24 months.) Had massive fiscal and monetary stimulus not been applied in October of 2008, after Lehman filed for bankruptcy, this most recent correction would likely have lasted at least 24 months.
  • If the dividend yield of the S&P 500 Index should go from a most recent 2% to 10% to kill the NIRPs and negative interest rates, the peak-to-trough decline of the Index would be 80%. The only other time over the last 100 years in the U.S. that a decline of more than 50% occurred was from 1929 through 1932. After the market had declined by an initial 40% in October of 1929, the market experienced six powerful rallies that generated trough-to-peak rallies providing returns ranging from 20% to 50%. When the market finally bottomed in the middle of 1932, it had declined by 90% from its 1929 all-time high. I would expect no less drama from a secular bear market that was likely birthed after the market hit an all-time high in May of 2015.

The most important issue remaining is that of timing, and when the S&P 500 Index will begin to ratchet downward to new multi-year lows that could eventually take the Index to well below 1,000 by late 2017 or early 2018. The latest significant developments are the NIRP Crash Indicator going to an Orange Pre-Crash reading on April 1, 2016, and the heightened volatility that followed for the Japanese yen and all of the world's major stock indices for the week ended April 8, 2016. They have increased the probability that the mark-down of the world's income-producing assets will begin in 2016.

Assuming that the renewed volatility proves temporary, there will be plenty of reasons for the market to have an excuse to go to new lows between now and the end of 2016. Extreme controversy surrounding NIRPs and negative interest rates will continue to escalate. Because NIRPs were created by the world's central banks and bankers who have obtained rockstar status, the next downturn to lower lows will likely be fueled by public statements that will be made by central bankers about NIRPs, negative rates, stimulus, currencies and the health of economies, etc.

From April through December of 2016, each of the world's three leading central banks have six scheduled public policy meetings. The most probable outcome will be that the S&P 500 and the indices for the other global markets will hit new multi-year lows during some or all of the months the meetings are scheduled.

Schedule of Remaining Policy Meetings of Central Banks for 2016

European Central Bank (ECB)

Bank of Japan (BOJ)

U.S. Federal Reserve (FOMC)

April 21, 2016

April 28, 2016

April 27, 2016

June 2, 2016

June 16, 2016

June 16, 2016

July 21, 2016

July 29, 2016

July 27, 2016

September 8, 2016

September 21, 2016

September 21, 2016

October 20, 2016

November 1, 2016

November 2, 2016

December 8, 2016

December 20, 2016

December 14, 2016

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Based on my analysis, I am recommending that the shares of the Utilities Select Sector SPDR ETF (NYSEARCA:XLU) and the shares of its components be sold at their current prices. The shares of the companies that I am recommending be sold include NextEra Energy (NYSE:NEE), Duke Energy (NYSE:DUK), Southern (NYSE:SO), Dominion Resources (NYSE:D), American Electric Power, Exelon (NYSE:EXC), PG&E (NYSE:PCG), PPL (NYSE:PPL), Sempra Energy (NYSE:SRE) and Edison International (NYSE:EIX). The share prices of the XLU and its components have increased by an average of 10% since the beginning of 2016 as a result of investors seeking shelter from the market's extreme volatility. Investors have bid up the share prices of most utility companies to all-time highs since the start of 2016. Unfortunately, when the mark-downs begin, shares of utility companies will decline significantly along with all other non-sovereign income producing assets. Utility companies and related mutual funds, and ETFs should be sold, and should not be repurchased until negative interest rates have been eliminated.

Sell Recommendations for Utilities and ETFs

Utility/ETF

Symbol

Price @ 04/08/16

Utilities Sector SPDR

XLU

$48.85

Duke Energy

DUK

79.77

NextEra Energy

NEE

116.81

Southern

SO

50.73

Dominion Resources

D

73.04

American Electric Power

AEP

66.01

Exelon

EXC

34.70

PG&E

PCG

59.30

PPL

PPL

37.40

Sempra Energy

SRE

104.24

Edison International

EIX

70.69

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.