It’s a Small World

It’s a small world.  But not in the eyes of the current administration as Trump publicly rejected globalization in his United Nations speech yesterday.  The admission served to weaken an already shaky market with investors not quite over their trade fears from Monday’s session.  The S&P500 and Dow Jones Industrials both closed near session lows with the Dow closing right on around a weak support line at 26500.  As mentioned yesterday, both of the two indices have very little in the way of support in these thin upper areas of their ranges, though they are both right below all time highs.  The small cap Russel 2000 managed to pull off a small gain yesterday but it continues to languish in a sideways trading pattern, which is uncharacteristic of the index, certainly in 2018.  In times of stress investors turn to the tech sector to sooth an upset stomach and that is what they did yesterday, repeating the oft-used strategy.  Side note:  as per my yesterday’s note, the tech sector is no longer technically the tech sector (oblige my literary license here) as it is now split between information technology and communications services, but when I use the term “tech” I refer to it in its classic form.  That being said, the tech-heavy NASDAQ 100 gained in yesterday’s session in evidence of the tech trade.  The NASDAQ is right around a point of soft resistance but still right in the middle of a range bound by a 7400 support line and its all time high of 7691 (see chart 8 in my attached daily chartbook).  All equity indices remain constructive.  While stocks have largely been responding to trade concerns, bonds are different story altogether.  It is no secret that yields have been creeping up – I make sure and let you know every day – but if you browse chart 20 in my attached daily chartbook you will see just how extreme the move has been since late August.  Ten year yields traded as high as 3.11% yesterday closing slightly lower at 3.09%.  The recent move is the result of 2 principal factors: interest rate hike expectations and supply / demand.  There is evidence that Japan has been selling US Treasuries in favor of European debt and Japan is one of the largest holders of US Sovereign debt (they are actually the second largest behind China).  There is much speculation about the attractiveness of fixed income yields above 3% relative to the dividend yield of the S&P500, which is only 1.8%.  Last Wednesday I delved into what makes up yield to maturity, so it is only fitting for me to talk about the other side of the equation, as it is geek-out Wednesday.

A dividend is payment made by a corporation in the form of cash or stock and is decided on by the board of directors.  The theory behind dividends is that it is a tool for corporations to distribute profits to shareholders in lieu of retaining the earnings.  Dividends are most often issued monthly, quarterly, or even annually but they can also be issued in one-time gestures.  Dividends are often expressed as dividend yield, which is simply calculated by dividing the annual dividend payment by the price of the stock (which is the most common way).  Though yield seems like a simple way of looking at dividend it is important to recognize that dividend yields may appear less attractive when a stock’s price is higher often clouding the judgement of investors.  For example, let’s say that an investor purchases a stock for $10 and it pays a $1 annual dividend.  The dividend yield for that investment is 10%.  Now let’s say that the company does well and the stock trades up to $20 – wow even better.  Now let’s say the investor runs into her friend at the gym who tells her that he knows of a stock that is really cheap with a dividend yield of 10%.  The investor goes home and looks up the dividend yield of her current holding and it is now only a mere 5%.  Thinking that the dividend has gone down, she calls up her broker and decides to sell the stock and buys the new stock yielding 10%.  What she may not have known was that the new stock only pays a $.50 dividend and its current price is $5 and that it has been trading down due to missing earnings targets.  So what is the moral of the story?  For investors looking to add income using dividends, it is first important to look at the health of the company, but more importantly to make sure that the “actual” cash flow from the portfolio meets their needs.  When looking at the health of a company, dividend investors typically look at the company’s history of paying dividends.  Companies whose dividends have been stable and are growing are favorable over those with a spotty or receding dividend.  An investor can also look at the ratio of dividends to earnings per share.  This ratio will tell the investor how much of earnings is used to pay dividends.  If the ratio is high relative to comparable companies, an investor may be concerned that the company is more focused on keeping investors than the future growth of the company.  Investors may also choose to delve a bit deeper to try and find out where the cash for the dividend is coming from.  Though in its strictest form, a dividend is a debit to retained earnings, which come from (as the name implies) earnings.  Accounting can be tricky (though it shouldn’t be) and just because there are earnings that doesn’t necessarily mean that there is cash on hand to pay dividends and lower quality companies do all sorts of things, even borrow money, to pay dividends on time.  Now that said, what about taxes?  Dividends come in two forms, qualified or unqualified.  A qualified dividend is one paid by a US company or one that operates principally in the US and comes from a stock which is held for more than 60 days over a period of 120 days. Qualified dividends are taxed at 0, 15, or 20% based on an investor’s ordinary income tax rate. Unfortunately, the more you make the more you pay.  And oh, if you make more than $200k a year, you may be subject to an additional surtax.  It would not be fair if I didn’t mention that there are state taxes as well (as high as 13% if you live in California).  If the dividends are not qualified, you will pay ordinary income tax.  Most typical common stocks pay qualified dividends, but investors need to check with their advisors before purchasing.  While we are talking about taxes, a US Treasury bond, which is backed by the US Government (so you can count on getting your principal back), is tax free on the state and local level but it is fully taxable at the federal level.  Municipal bonds are all different but many are not taxable at the federal level and generally not taxable in the state where the bonds are issued.  Of course munis do come with more risk than US Treasuries. So the bottom line is that investors need to look carefully at their precise cash flow needs, their level of risk tolerance, and their tax situation in comparing income received from stocks or bonds. The best way to start is to call your wealth manager.

Today we get new home sales, which is expected to have grown +0.5% month over month to 630k units after falling -1.07% last month.  Today there will also be much noise about President Trump’s speech and more Kavanaugh, though they should have no real quantifiable effect on the markets. Trade fears will continue to dominate today as well.  The real news today will come at 2:00 PM EDT when the Federal Reserve’s Open Market Committee will announce its rate decision.  Though a 25 basis point hike is almost certain, traders will be most interested in the Chairman’s press conference and the all-to-familiar dot plot.  The dot plot shows rate projections of FOMC members and many will be watching to see if there are markable changes in those projections – will they be speeding up or slowing down.  The release will surely impact treasuries and could impact the equity markets as well.  We can certainly count on volatility as traders, and yes the world, awaits the Fed’s release.

daily chartbook 2018-09-26