Beware the Dividend Trap

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The Dow finished down 250 points in the US on Friday, or nearly 1.5%. Gold was up nearly US$25. Just like old times!

Apparently, the fall in US stocks had something to do with weaker–than-expected fourth quarter economic growth numbers. Real GDP grew by 2.6% annualised compared to 5% growth in the third quarter.

Of greater concern was the sharp drop in ‘real final sales’, which seeks to measure underlying demand in the economy by removing the effect of inventory growth or depletion. On an annualised basis, real final sales growth was just 1.8%, down from 5% in the third quarter.

Clearly, there was a noticeable slowing in US economic growth at the end of last year. But GDP data is a lagging indicator, so whether it really influenced the market on Friday is questionable.

As I wrote last week, the US market looks like it’s in a correction/consolidation period…regardless of the data flow. Let’s take a look at Dow Jones index…it’s been a while since you’ve seen it here.

Over the past three years, the Dow has rallied strongly. After a sharp correction in October, the index surged to new highs in early and late December 2014. But it’s since fallen again. If the Dow falls below the mid-December low of around 17,000 points, it could quickly lose another 1,000 points and head toward the October 2014 low.

Given the size of the advance over the past few years, such a correction would not be unusual. However, the bears will come out growling should the Dow break the October low, as such a move would signify a much deeper correction is on the cards.

What could be the cause of the current correction? The strong US dollar comes to mind. The Dow is full of multinational companies that earn a decent amount of revenue and earnings from foreign markets. The strong dollar, combined with slowing growth in these markets, will have an effect. Perhaps the market is starting to price this in?

This won’t come as a surprise to subscribers of Phil Anderson’s Cycles, Trends and Forecasts report. Phil’s been preparing his readers for a correction (not a crash) in early 2015.

It’s a different story in Australia though. There’s a whiff of an interest rate cut in the air and investors love it. In recent weeks, Australia’s bellwether financial stock, the Commonwealth Bank [ASX:CBA], broke out to a new high and briefly touched $90 per share.

The reason is simple. Lower official interest rates translate into the prospect of more housing market speculation, which CBA will benefit from. In addition, the lower cash rate makes the banks’ dividend yield more attractive, so the share price rises as investors ‘chase’ this yield.

That’s why Telstra’s [ASX:TLS] share price is at multi-year highs. Investors are treating these yield stocks like bonds that have an almost guaranteed income stream, not equities where the dividend is variable.

That’s all well and good while earnings grow and the dividend is at least maintained. But as soon as there is an earnings hiccup, the share price will be in trouble.

Take Woodside [ASX:WPL] for example. There is a story in the Financial Review today about how investors saw it as a dividend stock and piled in.

Based on 2014 dividends of $3.06, the stock currently trades on a historical dividend yield of nearly 9%. Even at the peak price last year of around $44, it traded on a yield of nearly 7%.

But this is a resource company we’re talking about. You should never buy a resource stock for its yield. In fact, whenever the yield on a resource company grows in excess of 4-5%, it’s a sign that the market doesn’t believe it’s sustainable.

That was exactly the case with WPL. Dividends are likely to halve this year…and even that is being optimistic. The stock price has fallen a relatively benign 22% from its peak in August last year. There’s probably more to come. Here’s why…

Based on consensus earnings estimates for 2015, WPL trades on a price-to-earnings ratio of 18. That’s expensive. It means investors clearly think oil prices and profits will rebound pretty quickly.

If the oil price doesn’t rebound, expect WPL’s share price to fall much further this year. Based on the current oil price, the stock is very expensive.

The risks of investing in energy-related stocks versus banks or Telstra are clearly different. But the point is, when a stock trades more like a bond than equity (a part ownership in a business with variable earnings and dividends), then risks increase considerably.

For example, nearly everyone thinks that the RBA will cut interest rates tomorrow afternoon. For the past few weeks, the market has been moving higher on the assumption that lower official interest rates will make stocks more attractive. Lower rates are already factored in.

So the big risk is that Glenn Stevens doesn’t deliver. On Friday, I explained why Stevens might disappoint the market. I’m sticking with the no rate cut call and if he indeed keeps rates on hold for another month, you can expect a market sell-off.

Along with expected weakness coming from US markets (mentioned above) that could mean the Aussie market is in for another correction too.

In other words, same old, same old. For the past six months, increasing volatility has characterised the Aussie market. Big rallies have followed big sell-offs. Thanks to the prospect of more interest rate fuel, the market is back near the highs reached in August last year. It’s probably time for another pull back.

While I don’t think the RBA will cut tomorrow, given the dire state of the Aussie economy, I do expect more cuts in 2015. It’s only a matter of timing. And as long as the blue chip stocks maintain their earnings and dividends, lower interest rates should put a floor under the market.

That’s assuming nothing else pops up to worry investors, which is a big assumption. Keep your eye on Greece and Europe, dear reader. That’s where the action is right now.

Greece is the key to the whole Eurozone project. If Greece is serious about reducing its debt and not just being dictated to by its creditors, you’re going to see some fireworks in Europe soon.

Regards,

Greg Canavan+
for The Daily Reckoning

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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