Second hand pushes midnight again
Dividend stocks are likely to disappoint trusting investors as portfolios will inevitably be less diversified. And with an end to Bush tax cuts in sight, they might be frightened off completely.
No free lunch
Dividends are perennially popular but advisers and wealth managers have embraced them with renewed fervour. Their enthusiasm makes sense in a low yielding, fixed-income environment, with investors still battered after waves of volatility.
This crowded dividend trade is not without its risks, however. Chasing yield can lead a portfolio in unintended directions, warns Rod Greenshields, consulting director of US private client services at Russell Investments. He says: “A dog will chase a bird right through traffic.”
One unintended consequence of a dividend-rich strategy is that portfolios will end up overly concentrated in just a couple of sectors. Decades ago, dividend enthusiasts could still construct a broadly diversified portfolio but that is no longer true. Now, 71% of the highest yielding securities in the Russell 1000 Index happen to be located in the financial services and utilities sectors.
Utility companies face several headwinds, ranging from environmental problems (think BP) and deregulation, to liquidity risks for rolling over their debt. Financial firms have been put through the wringer since 2008, and are still struggling to regain stability.
What explains investors’ long-term attachment to dividends? Greenshields attributes that loyalty in large part to behavioural impulses, driven by a propensity for mental accounting, for creating a more comfortable psychological framework. (Stateside continues below)
Investors say they can spend their dividend cheques without risking running out of capital. When those quarterly cheques show up with the mail, the envelope seems “more concrete and substantial” than the nebulous concept of total return, Greenshields explains.
Consider a parallel with the American food packaging industry. In recent years, the phenomenon of 100-calorie packs has exploded, creating artificial boundaries over what eaters put into their mouths.
Treats may not feel like junk if packaged in smaller doses, and people will eat half a dozen of them. In other words, how anything is framed or packaged affects how we perceive it.
Eating seedcorn poses problems. The more a firm distributes in dividends, the fewer resources it may have left to reinvest in business opportunities. The underlying reality of total return stays constant. Students of financial theory will recall Franco Modigliani and Merton Miller, who developed a theorem known as the capital irrelevance principle.
Assuming no frictions, such as taxes or transaction costs, investors should be equally happy to receive their returns in the form of share price appreciation or dividends.
Over the cliff
Adding to headaches, dividend investors face the sunset of the Bush tax cuts at the end of 2012. Ending those measures, enacted in 2001, 2003 and 2010, could raise dividend taxes from 15% to the much higher rates of ordinary income.
Let’s do some quick maths. Supposing the 15% rate catapults dividend taxes to 43.4% for high earners. If you receive $10 today in dividends, you can keep $8.50. If rates shoot up, you will only take home $5.66, so the share price would have to fall to keep the yield stable.
It is considered likely that Congress will postpone the tax bite yet again - but it is by no means certain. The fight will be fierce. On one hand, the Congressional Budget Office has estimated that the expiration of all the tax cuts would swipe $500 billion, or 4%, from the American economy - always a nasty shock, especially during hard times. On the other hand, more postponements will add to massive national deficits and could prompt further rating agency downgrades of the country’s debt.
According to the Committee for a Responsible Federal Budget (CRFB), a bipartisan non-profit group, the cost of capital gains and dividend tax relief would amount to $25 billion by 2014 and $55 billion by 2022.
The choice is grim: a fiscal cliff versus accumulations to the mountain of national debt. The CRFB pleads for action, sooner rather than later, consisting of a gradual, thoughtful plan to stabilise and reduce the debt. It advocates “spending cuts on low-priority spending and on changes which can help to encourage growth and generate revenue through comprehensive tax reform which broadens the base.” That benign-sounding prescription is a lot easier said than done.
A bumpy journey
Dividends could serve as a canary in the coalmine. Later this year, keep an eye on how those generously yielding stocks perform relative to the entire market. If they start to lose steam, it may indicate that investors are fretting seriously about tax rate renewals. The stockmarket is notoriously myopic but as the end of the year approaches, investors will refocus on the fiscal cliff.
Or rather, think of two fiscal cliffs, with a narrow gorge in between. It may be that Congress averts a dividend tax rate crisis but it must walk a tightrope from one side to the other. “The central tendency is still to reach the far side,” says Donald Luskin, the chief investment officer at Trend Macrolytics LLC. “It’s like an airplane. If anything goes wrong, everyone gets burned. Either way, the flight will be bumpy - there might even be a mid-air collision - but we may still land.”
There is no room for complacency. Economists at Goldman Sachs have assigned probabilities to the range of scenarios. While their base case remains a short-term extension, with an expectation of a longer-term resolution, they ascribe a 35% probability to the outcome that all the tax cuts expire, if politicians cannot compromise.
One can already start to measure the political temperature. In 2010, before the mid-term elections, key Democratic senators dropped some startling hints in favour of extending the tax cuts. “So we should again look for something amazing and unexpected from politicians, as an indication that the process might turn out to be sane,” Luskin recommends.
Meanwhile, the crisis last August over raising the national debt level was barely salvaged, when less was at stake. Even then, the second hand nearly reached midnight. Next time, it may tick over.
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