Weekly Update: Don't call me old

08-31-2018

I have been a fan of the high-quality dividend strategy for the last 10 years. Many others have, as well. Among some, though, this approach got confused with a momentum strategy during the middle part of this decade, when long rates were trending down, making dividends all the more attractive. But since the 10-year Treasury yield found its nadir at 1.37% in early summer 2016 and has gradually trended up, dividend stocks have underperformed the S&P 500 by 30 to 40%! They no longer are expensive versus their long history. And with the yield curve continuing to flatten, investors have renewed interest in some of these beaten-down sectors. Still, in my travels, there remain many dubious advisors. And the very best question of all concerns the changing landscape of American business. “Does the strategy own yesterday’s business models?” The dividend strategy analysts I know bristle when their companies are labeled “old economy.’’ What’s old about today’s utilities? These companies have transformed themselves in the last 15 years, moving away from coal toward renewable energy, particularly natural gas, but also more toward wind and solar. They provide gas and electricity lines into homes and businesses, allowing consumers and businesses to charge cell phones, power up the Wi-Fi and computers, and operate mega data centers. Some of the best dividend payers represent the infrastructure components—not the power generators where price competition can be fierce—with earnings protected in the sense they are regulated by utility commissions.

Consumer Staples is another sector that often comes under fire for being subject to the pricing pressure of the so-called Amazon effect. But not all consumer segments are created equal. For example, tobacco—which typically represents a large share of Consumer Staples exposure in dividend strategies—has been experiencing a rising pool of global nicotine consumers since 2012, allowing companies to raise prices 4-6% annually. As producers of popular small-ticket items that are too heavy and costly to ship, big-name soft drink makers similarly represent Consumer Staples holdings that tend to avoid the Amazon effect. What’s old economy about Telecom? Computers, smartphones, wireless communications and the growth of data all come back to the technology that makes the internet work. If you want to be connected, you need this sector. Telecom companies dominate the spectrum, have huge networks in place and extremely high barriers to entry—they continue to replace copper with fiber, vastly improving capacity, cost efficiency and streaming capabilities. They also provide “new economy’’ exposure via Real Estate Investment Trusts (REITs) involved in financing the towers so integral to making wireless technology work or the industrial and office space that house huge data and R&D centers.

Integrated energy companies don’t just do oil. They have businesses in chemicals, gas, exploration and production, midstream, pipelines, refineries—all part of a value chain that isn’t going away. And the Energy sector is perhaps the biggest user of technology. Big oil platforms in remote or dangerous areas can now drill with no one on the platform, reducing risks and costs, while shale producers keep extending the reach of a single rig, further lowering their breakeven production costs. For those wondering if electric vehicles threaten future demand for oil, consider 1) estimates suggest vehicles on the road globally will double by 2035 and 2) cars only represent about a fifth of oil’s usage today. Of all sectors, Health Care is possibly the easiest to defend from the “old economy” slight. It costs $2 billion today to get just one drug approved! Biotech companies are exciting, but in order to scale they must partner with large pharmaceuticals. Furthermore, many companies in this sector have diversified revenue streams and boast balance sheets of such magnitude and high-quality that they can maintain and grow dividends even as big drugs lose patent protection. It takes large balance sheets to allow for significant R&D. So I ask you, dear reader, does any of this sound like “yesterday’s business models?” I’m a dividend fan!

Positives

  • Consumers are bullish … The Conference Board confidence gauge jumped to an 18-year high, with an increasing number of consumers saying they plan to make big-ticket purchases over the next six months, including homes, cars and major appliances.
  • … and they are spending The latest weekly Redbook same-store sales measure jumped 5.1% year-over-year (y/y), its third fastest pace of growth this year, while the ICSC’s weekly sales gauge moderated but remained above trend. This all suggests consumer spending, which rose a solid and in-line 0.4% in July, should remain robust heading into fall.
  • Q3 growth off to a good start After acting as a drag in Q2, inventories surprisingly jumped in July, offsetting a negative from trade (see below). Elsewhere, the Chicago Fed national activity index eased after a very strong June while regional Texas and Richmond PMIs accelerated. Growth advanced at a 4.2% rate in Q2 following this week's upward revision on increased capital expenditures.

Negatives

  • Housing's doldrums A month after pending sales unexpectedly rose, they fell back again in July, pushing the y/y rate further into negative territory. Mortgage purchase applications also fell off, although they remained up y/y. Prices moderated but continued to run ahead of inflation, further undermining affordability along with higher mortgage rates.
  • If we're ever going to get inflation, this would be the year Prices continue their gradual upward trend, with the core PCE index rising 2% y/y in July, up from June's 1.9%. This matches the Fed’s target and supports its ongoing gradual rate-hike path. Consumer inflation expectations hit a 4-year high in the final Michigan sentiment reading for August.
  • Tariffs hit trade After adding significantly to Q2 growth, trade looks to be a drag for Q3 as the goods deficit hit a 5-month high in July and, on a 12-month basis, reached nearly a 10-year high. The major culprit was a big drop in food exports primarily because of tariffs.

What else

Age is relative Strategas Research is among those who don't fully accept that this is now the longest equity bull market on record. It notes that in both 2011 and 2015, there were deep drawdowns at the individual stock level with over 70% of issues down 20% during the former and 63% during the latter. The Russell 2000 index fell roughly 30% in 2011 and 27% in 2015. And global equities have endured similar or worse sell-offs. Ultimately, while the S&P may not have reached the 20%-decline threshold many consider to define true bears, it did not decisively breakout relative to bonds until late-2016. By that measure, Strategas says the current bull's barely 2-years-old.

How much higher? Many equity investors are asking this question now that the S&P has reached a new closing high after 145 trading days. In seven similar bull markets where there was a pause of at least 126 days between cyclical highs, the cyclical bull continued for 129 more days and gained an additional 13.8%, according to the median stats as compiled by Ned Davis. In five of the seven cases, the S&P gained at least an additional 10% before the start of the next cyclical bear.

Boomers need millennials to invest A Gallup poll found only 38% of adults under 35 have investments in public companies, down sharply from 52% just before the global financial crisis. Strategas Research suspects this simply reflects the fact that household formation is occurring later and later in one’s life, and posits that young adults eventually will see the need to invest for the long term as they get married and start families. It also expects intensifying debates about Social Security’s and Medicare’s sustainability will further underscore the importance of investing.

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