Stocks are rallying for a bizarre reason.
Two weeks ago, the S&P 500 set a new all-time high. It was its tenth new high since July 11.
What's more, stocks are rallying despite nearly impossible odds:
The global economy is stalling. The U.S., Europe, Japan, and China are all growing at their slowest rates in decades.
Stocks are expensive. According to the CAPE valuation ratio, U.S. stocks are 62% more expensive than their historic average. CAPE gives a long-term view of the S&P 500.
Worst of all, corporate profits are plunging. Earnings for companies in the S&P 500 are on track to decline for the fifth straight quarter. That hasn’t happened since the 2008–2009 financial crisis.
Normally, periods of falling earnings have led to bear markets. That’s because earnings are the most important driver of stocks.
According to The Wall Street Journal, the S&P 500 has historically been about 90% correlated with earnings. In other words, stocks and earnings are supposed to move together.
But right now, stocks are rising while earnings decline.
This year, the correlation between the S&P 500 and its earnings has turned negative, to about -0.20.
Today, we’ll tell you what reckless behavior is fueling the stock market. As you’ll see, this can’t keep stocks afloat for much longer. We’ll also show you how to protect yourself from this dangerous situation.
• Investors are “reaching for yield”…
For the last eight years, the Federal Reserve has held its key interest rate near zero.
The Fed cut rates during the financial crisis to get folks to borrow and spend more money. According to the government’s flawed economic models, this would grow the economy.
It hasn’t worked. The U.S. economy is “recovering” at the slowest pace since World War II. Last quarter, the economy grew just 1.2%, less than half its historic growth rate.
• The Fed also made it very hard to earn a decent return…
You see, the Fed’s key rate sets the tone for all other interest rates.
By holding its key rate near zero, the Fed made it incredibly cheap to borrow money. It also made it difficult to earn a decent return in the bond market.
Take the 10-year Treasury. From 1962 to 2007, 10-years paid 7.0% in interest. Today, they yield just 1.6%.
Corporate and municipal bonds also pay about half of what they did nine years ago.
These days, you need to own risky assets to have any chance at a decent return.
• Investors have piled into stocks that pay dividends…
The Dividend Aristocrats Index, which tracks companies that have increased their dividends for at least 25 consecutive years, has climbed 275% since March 2009. The S&P 500 is up 221% over the same period.
According to The Wall Street Journal, dividends have become a driving force of the stock market:
The five-year rolling correlation between S&P 500 companies’ dividend yield and the index’s performance has been at 0.80 or above for the five quarters through June, according to S&P Global Market Intelligence. That is the highest since 1993 and up from an average of minus-0.1 dating back to 1941.
Keep in mind, the correlation between earnings and stocks has plunged to -0.2. This means dividends have more impact on stocks right now than earnings. This is almost unprecedented.
Since 1941, the correlation between stocks and dividends has been -0.1, meaning they’ve had almost no impact on the performance of the S&P 500 for the past 75 years.
• U.S. companies are paying near-record amounts of dividends…
The Wall Street Journal reported last week:
At the end of June, the annual dividend level of the S&P 500 components was the highest in quarterly records going back to 1936. The dollar amount of payouts was just shy of a record last quarter but is poised to mark new highs this quarter, according to S&P.
According to The Wall Street Journal, companies in the S&P 500 are spending more than one-third of their profits on dividends:
Payouts at S&P 500 companies for the past 12 months amounted to almost 38% of net income over the period, according to FactSet, the most since February 2009.
Some companies are paying out more in dividends than they make in profits. The Wall Street Journal continues:
In the second quarter, 44 S&P 500 companies paid an annual dividend that exceeded their latest 12 months of net income, the FactSet data show. That is the most in a decade and a practice some analysts deem unsustainable.
Iconic American companies like pharmaceutical giant Pfizer (PFE), toymaker Mattel (MAT), and food staples Kellogg (K) and Kraft Heinz (KHC) are among those paying out more in dividends than they earn in income.
• This isn’t sustainable…
According to credit rating agency Standard & Poor’s, “there will come a point when dividend growth will be slowed if earnings and sales don’t improve.”
According to FactSet, analysts expect third-quarter earnings for the S&P 500 to decline 2.1%. This would mark the sixth straight quarter that earnings have declined from the previous year.
Also, keep in mind that Wall Street expected third-quarter earnings to rise 3.3% as recently as March 31.
If earnings continue to fall, many companies will stop raising their dividends. Some will have to cut or even stop paying their dividends.
This could trigger a huge selloff in certain dividend-paying stocks.
• We encourage you to take a good look at your portfolio…
If you own a stock that pays dividends, make sure its dividend is sustainable.
We recommend you avoid any company that pays more in dividends than it makes in profits.
You should also stick with companies that have proven dividend track records. If a company has increased its dividend for more than 10 years in a row, you know it can manage its dividend through ups and downs of the business cycle. Those are the companies you want to own for the long haul.
Finally, steer clear of heavily indebted companies. If the economy runs into serious problems, many companies will struggle to make money. Companies with too much debt may have to cut or stop paying their dividends in order to pay their debts.
• We also encourage you to own gold…
As we like to remind readers, gold is real money. It’s preserved wealth for centuries because it’s unlike any other asset. It’s durable, easy to transport, and easily divisible.
And unlike paper currencies, gold’s survived every financial crisis imaginable. It’s the ultimate safe haven asset.
We recommend most investors put 10% to 15% of their money in gold. This small position could protect you from catastrophic losses if stocks tank.
If you want to buy gold, watch this presentation first. It also reveals a “loophole” in the gold market. In short, one of our analysts discovered one of the best deals you’ll ever see for gold coins.
But you'll want to act fast. As you’ll see, the price of gold could soon take off. Click here to learn more.
Chart of the Day
Beware of companies that promise fat dividends.
Today’s chart compares forecasted with realized dividend yields for companies in the S&P 500.
You can see most companies over-promise and under-deliver when it comes to dividends. In fact, based on data going back to 1996, you’re likely to earn a bigger dividend by investing in a company that projects to pay a 3%–4% dividend versus one that projects a double-digit yield.
So, if a company’s dividend yield sounds too good to be true, it probably is. This is another reason why we like to invest in companies with proven dividend track records.
Delray Beach, Florida
August 29, 2016
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