Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
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EQ: As investors anticipate the eventual rise in interest rates in the coming months, there’s an understanding that stocks will take a hit as a result. In this week’s Sector Watch report, you discussed the primary reasons for why this typically happens. Can you tell us about the primary factors?
Stovall: We know that interest rates have already risen. On May 3, we were down to 1.7 percent on the 10-year note but we’ve been creeping our way higher to about 2.9 percent recently, and are currently hovering around that 2.5 to 3 percent area.
The reason why higher rates typically cause some pressure to occur on stock prices is four-folds, at least. First off, they slow economic growth as consumers and businesses increasingly balk at the rising credit costs associated with expanding or upgrading.
Secondly, they lead to increased interest expense as long-term debt is rolled over. Third, they reduce the resulting intrinsic value of share prices from discounted cash flow models. Lastly, they increase the attractiveness of bonds as the interest rates rise.
I could also probably add a fifth pressuring factor in dividends, because rising rates make the burden of paying these high yields more onerous for companies as they likely require increased payout ratios during a flattening or declining earnings per share phase, which results from a slowdown in economic growth.
EQ: Dividend stocks, which most had enjoyed outstanding performances during the low-rate environment, may be most susceptible to a pullback here. Do you anticipate a significant about of dividend cuts on the horizon?
Stovall: I don’t envision there to be too many dividend cuts mainly because the payout ratio right now for the S&P 500 is only at 36 percent, as compared with the long-term average of 52 percent. There’s an awful lot of cash on the sidelines and I think investors are telling company management to do something with that money. Most likely, they’re hoping that the decision will be to increase dividends for shareholders.
However, those companies that are paying high yields are, in many ways, viewed as surrogates for bonds. So if bond prices rise, and therefore become more attractive over time, that puts some pressure on stocks, especially on the higher yielding areas.
The three sectors with the highest dividend yields are Telecom Services at 4.8 percent, Utilities at 4.1 percent, and Consumer Staples at 2.8 percent. Interestingly, these were the three worst-performing sectors going back to May 3. The price changes that we saw for these sectors were declines of 8.6 percent for Telecom, 8.2 percent for Utilities, and 2.8 percent for Staples. Everybody else was in positive territory.
EQ: What are some characteristics dividend investors should look out for to gauge signs that a yield cut may be on the horizon?
Stovall: It’s an interesting point because people shouldn’t yield to temptation, because a high yield could be a sign of a problem that’s right around the corner. It may indicate that maybe the smart money has already sold out, thus pushing the share price lower and making the yield seemingly higher based on the most recently paid dividend as a result. People might have also bailed out in anticipation of a dividend cut, which is not a good thing.
I think there are two things that investors can look at to help them to decide whether a company could have some problems.
First off, the payout ratio in terms of what the company pays in the form of dividends as compared with cash flow. I wouldn’t necessarily use earnings, which could also be effected by noncash events such as depreciation. Comparing the dividend payout with cash flow, or basically how much money you have on an ongoing basis to pay those dividends, is more important.
You could come up with a threshold that says maybe 70 percent and above is a little bit too expensive. However, it’s important to also take a look at it from an industry-to-industry basis because some higher yielding industries like Utilities normally pay a very high payout ratio. So be careful not to make too much of a blanket statement there.
Another thing to look at is the debt-to-capital ratio, or in other words, the amount of debt the company has to service over time. A very high debt load will increase the interest expense over time in a rising interest rate environment because when the debt is rolled over, it ends up being rolled over at a higher interest rate. As a result, you end up having to pay more and more in order to service that same amount of debt.
EQ: Earlier this week, stocks experienced a sharp selloff, which was primarily attributed to the situation in Syria. Does this tension create additional uncertainty in a meaningful way for the market, which is already dealing with a few headwinds on the horizon?
Stovall: Yes, it does add to the uncertainty level. The essence of slumping investor sentiment can be summarized by Syria, seasonality, and sequestration. As you can probably tell, I like alliterations, but that is what the market is experiencing right now.
We’ve been aware of seasonality for decades in that the market tends to do quite poorly in the third quarter, specifically in August and September. The sequestration has been with us for maybe the last year in terms of worries. We’ve dealt with the fiscal cliff, the pending resolutions of the debt ceiling, and sequestration kicking in earlier this year. It does not really seem that Congress is addressing it.
Now, we also have the worries over Syria, but Syria has been a problem for more than two years. So it really is a question of how uncertain do we need to be? It may be because most investors and most people on Main Street really don’t want us to be entering another conflict in the Middle East.
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