The Hunt for Yield

I am not immune to the hunt. Yield can help you wait out a lot of volatility, and is especially important in times of questionable returns and incredibly low rates on savings. Pundits have been talking up the dividend yields of some brand name US firms such as JNJ or PG.Viewing the remainder of this article requires a Subscription

Deadly discount rate

We’re reading more and more about research being done in low to negative real interest rate environments. For example, what discount rate should we use for valuations? All the PE deals being struck, what WACC are they using? Who’s financing it at a fixed rate? For that matter, how are the banks figuring out their spreads over LIBOR?

We often go back to the same set of books and principles, and I’m reminded of Ed Easterling’s book Unexpected Returns. We are moving from a period of price stability to instability. It doesn’t actually matter for valuations whether we move towards inflation or deflation – both will be bad for stocks. That being said, I’m heartened by the articles coming out that hopefully provide a reality check. Today, for example, in the Asia Times, David Goldman highlights why a low interest rate environment makes today’s valuations look exceedingly expensive.This article is a great start to trying to measure the sensitivity of stocks to changes in the interest rate – AT THESE RATES. That’s they key. These are still not normal times! Goldman describes a (crude, but effective for order of magnitude) model to measure equity duration (interest-rate sensitivity).

The recovery of the S&P 500 since its March 2009 lows reflects an anemic level of earnings as well as a very low discount rate. A rise in the short-term interest rate (in reality, in the whole yield curve) could take a very big bite out of equity prices. I don’t quite believe that a 2% risk free rate implies a drop in the S&P by half — this is a numerical example rather than a realistic model — but it does highlight the sensitivity to watch out for.

To read the full article (which you should), click here.

Naysayers will tell you a lot of things about imminent recoveries, low relative P/E’s, or forward P/E expectations. I’m still wary of valuations based on unrealistic circumstances and inputs.

Lower dividends and higher prices

We continue to stress that the long-term fundamentals are not supportive of a major bull market. S&P is reporting that dividends will be down roughly 22% this year. Bull markets tend to start with extreme low valuations, including single digit P/E’s, high dividend yields, all with low margins (room for expansion). We have exactly the opposite in this market. The chance that a major bull market will start from today’s levels is incredibly low. Food for thought as I hear people recommending putting money to work into year-end.

http://www.marketwatch.com/story/dividends-for-sp-500-firms-down-214-in-2009-2009-12-07-1136440