Stocks Can’t Go Much Lower or Can They?
On August 13, 1979, Business Week announced on its cover: “The Death of Equities.” By the time 1982 rolled around, the market traded at something like 5 times earnings and around (maybe less than) 1 times book value. Brokerage and bank stocks were considered rich at 4 times earnings and 0.7 times book value (yeah, that’s 0.7 of book value). Some of these banks even had returns on equity nearing 20% and returns on assets of over 1%. Companies — many of them — traded at a discount to net/net working capital. And that wasn’t the whole of it. Electric utilities yielded up to 18%! Some industrials had yields of 8% and higher.
Why was all of this? One reason had to do, admittedly, with an inflationary environment where bond yields were equally steep. With respect to dividends, many were not considered secure. In fact, had yields stayed at those early 1980 levels and the economy had remained moribund, dividends, earnings, and the economy would have disintegrated. But behind that environment was the disinflationary-engine for ensuring the bull-market that ran, arguably, from August of 1982 until roughly the year 2000. And it is with that dreadful hindsight that those of us who were Wall Street traders and executives back then, view current pronouncements through a skeptical eye. When I hear “there isn’t much room for stocks to go much lower,” I am struck by the visions of these cheaper stocks that were, in fact, much lower.
Now, don’t get me wrong, I understand that this is not 1982 and that interest rates aren’t skyrocketing. But still, we are facing a world where rates can not go much lower (Fed Funds are around 1.2%; in 1991, for example, at the end of the First Gulf War, that rate was over 6%, giving the Fed plenty of room on the monetary front. In 1982 that rate was high double digits). A logical person might now argue that with $450 billion in yearly deficits as far as the eye can see, rates may go higher over the next year or two. Yikes! That might mean higher rates in a slow economy. Might not happen, but then it might too. Would that uncertainty cause stocks to get cheaper? It’s something to chew on, if nothing else.
Now on to the proposed dividend tax exclusion hailed by many as a cure for what ails this stock market. Enticing companies to pay out more in dividends as a way to reward shareholders and create new investment sounds sexy and smart. It even sounds frugal and safe. But is it necessarily conservative? Not if it’s mishandled to the same extent that the past decade’s capital expansion was butchered by managers trying to please Wall Street analysts, pundits, and misguided shareholders. And what makes anyone think that corporate America won’t screw up dividend payments any more than Tyco did acquisitions? When investors press management to return capital in the form of dividends, executives — in trying to curry favor, a higher stock price, and bigger bonuses — will accommodate whether or not it is in the company’s long term interest to be increasing those payouts. We’re left with dividends being raised one year only to be lowered in another. The uncertainty of dividend flows — and don’t kid yourself, it’ll happen — will make such old fashioned concepts as yield-support seem foolish. Just look at the tobacco companies like Carolina Group with a yield that has approached 10% in a world where short term interest rates are near zero. Uncertain dividends are not worth much. Perhaps worse than dividend cuts would be an investment world like the one in Europe where we have companies subjecting investors to those gawd-awful rights offerings, diluting the shares, in order to avoid cutting dividends, or taking on more debt to do the same thing. Now that’s a pyramid scheme if ever there was one.
Finally, in a market where companies pay out dividends instead of investing in their businesses, we will see dis-investment (by definition) and slower growth (a perceived or a real slowdown, it doesn’t matter which). A market with slower growth prospects trades at a lower multiple of projected earnings (that is, a lower multiple of lower projected growth since funds are being paid out, not reinvested). That’s kind of an ex-growth double-whammy, if you think about it.
So, where does that leave me? It leaves me shaking my head, not at all sure that cheap is cheap. Value, to turn a phrase, is in the eye of the beholder. For some of us who’ve been around, it still don’t look that cheap.
When interest rates start to climb – and climb they will one day – the reaction in this market will be ugly. For the few of us who’ve seen the power of rates (both up and down) there won’t be much of a surprise. For the majority of investors too young to have been there, it will come as quite a shock. In terms we are all familiar with, “Buyer Beware.”