Quick, think of the safest stock you could invest in right now…
Is it McDonalds Corp (NYSE:MCD), with its 3.5% dividend yield and long history of profitability? Maybe you came up with Proctor & Gamble (NYSE:PG) with its 3.1% dividend yield and products that nearly every consumer on the planet buys. Or perhaps you thought of Johnson & Johnson (NYSE:JNJ), a company with a 2.8% dividend yield and a line of medical products used around the world.
For decades, conservative investors have gravitated toward shares of large multi-national companies that pay reasonable dividends.
These companies were expected to be more stable than other “speculative growth” stocks because they had strong businesses that generated profits from diverse areas around the globe. Investors thought that if one country had a recession, multi-national businesses would be fine because they had operations in many other areas of the world that were doing just fine. And as long as these stocks paid a healthy dividend, investors were rewarded for holding their shares through any pullback or correction.
But today, some of the very strengths that made blue-chip dividend stocks attractive have turned into risks for these investments.
Two Significant Risks for Blue Chip Stocks
The strong US dollar has turned out to be a significant challenge for large multi-national companies based in the U.S.. When selling goods or services abroad, these companies generate revenues in anything from euros to yen to Canadian and Australian dollars.
These revenues (and the profits from these revenues) must be reported in U.S. dollars whether the company actually converts the foreign currencies or not.
The euro versus the US dollar has moved from its 2014 high near $1.40 to a less than $1.05 in the first quarter. Versus the yen, one dollar moved from where it could purchase 100 yen for most of 2014 to where it can now purchase 119 yen. Similar moves have taken place versus the Canadian dollar and the Australian dollar.
Multi-national corporations who pay most of their expenses in dollars have another problem. They are covering costs that are based in a strong currency and then selling in countries with a weak currency. It can be difficult to sell products like this competitively because costs are higher and yet the goods must be sold at a lower price to compete with local companies who may have lower costs in their home currencies.
The recent currency moves are significant compared to typical fluctuations. And this earnings season we are likely to see multi-national companies report disappointing earnings due at least in part to the strong U.S. dollar. Just this week, JNJ reported an 8.6% decline in earnings, partially blaming the strong dollar for its performance. JNJ receives roughly half its revenue from overseas.
A second risk for blue chip dividend stocks is the potential for an unwinding of the “reach for yield” trend.
Ever since the Fed lowered interest rates during the financial crisis, income investors have found it difficult to generate attractive yields from bonds or deposit accounts. Instead, these investors have been essentially forced to buy dividend stocks to generate similar income to what they used to be able to get from traditional fixed income products.
Today, blue chip dividend stocks are trading at high multiples compared to historical levels, as more demand for dividends has driven the price of these stocks higher.
The danger is that once interest rates begin moving back towards normal levels, these conservative income investors will move capital out of dividend stocks and back into fixed income securities. While the Fed’s timing for raising rates is still very uncertain, the low level of rates compared to historical interest rates makes it all but certain that the Fed will need to raise rates at some time in the next few quarters.
It is interesting to note that when the market pulled back at the beginning of March, the Dow (which is full of large cap dividend stocks) behaved very differently from the Russell 2000 index (which is made up of small cap stocks).
The Dow dropped from a high of 18,288.63 to a low of 17,579.27 – roughly a 3.9% decline. The Russel, on the other hand, dropped from 1,243.33 to $1,206.11, a smaller decline of 3.0%
What is even more impressive is that the Dow has yet to retake its March high, but the Russel made a new high before the month was over and this week hit 1,272.74 – up 2.3% from the initial high last month. Clearly investors are more interested in putting capital into small cap growth stocks than adding new capital to blue chip dividend stocks right now.
Bottom line, we see a significant amount of danger for blue chip dividend stocks over the next few months. This is disappointing for traditional income investors, but good news for those who are able to take advantage of put selling and covered call strategies, which will benefit from added volatility in as interest rates move higher and investors react to dollar related earnings disappointments.