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Dividend Stocks: A Brief Outlook

|Includes:Consolidated Edison Inc. (ED), JNJ, SO

The site mentioned below is a quantitative trading model site I run. The blow was originally published there.

If you have looked at my site you will notice that the majority of my models are built around dividend picks. That is because this is what I grew up investing in and what I know the best, thus what I can model for the best. That said, I am a bit worried that some time in the next few years a bear environment for dividend companies will start.

My argument is as follows:

The federal funds rate is currently at the zero bound. Interest rates can't go lower, and at some point, probably when the economy gets some sort of strength back, the funds rate will have to go up. When the funds rate goes up so will the interest rates on bonds. (I am not going to go into detail on this relationship. Its pretty interesting though. Google it if you are not aware of how the funds rate works).

Most dividend investors buy those stocks to earn a yield. When the yields on bonds start to rise the risk-reward relationship will start to favor more and more bonds, leading to greater demand for bonds and lower demand for dividend stocks. Although the increase in demand for bonds will put upward pressure on bond prices (and thus downward pressure on their yields) the tie with the funds rate is strong enough to preserve higher interest rates.

With preserved higher interest rates and lower demand for dividend stocks, the price of dividend stocks will fall until the yields have an attractive premium versus bonds once again. Where this point is, is probably company specific and difficult to predict for the market as a whole. I would, however, be surprised if, at a funds rate of ~4% most utilities yielded 5.5-6% instead of the 4-4.5% on many of the better companies we see today. I suspect pipelines and trusts will probably yield around 6-7% again and many similar yield figures of the past will return.

So, when will the federal reserve start raising the funds rate? I would guess when GDP growth is a solid 3-4% a year and inflation is starting to kick in. I say this because inflation and solid GDP growth are signs of a strong economy. Without a strong economy if the funds rate is raised it will damage an already weak lending market that we can ill afford to have go sour again and will generate downward pressure on investment needed to spur growth.

So, when will the economy turn around? No one knows for sure, but I will go over the major market indicators and the macro situation in my next post. My goal with the next blog is to create a guesstimate for timing and the market.

Stocks: ED, SO, JNJ