Which would you prefer?
A fully franked dividend of 5% paid by a blue chip company OR term deposit interest of 2%?
If the world was one-dimensional, the answer would be a no brainer…take the 5% fully franked and laugh all the way to the bank.
But the investing world is far from one-dimensional. There are so many moving parts to consider. Actions have reactions.
However, most people look at the investing proposition in black and white terms.
Even if there’s a modest downturn in markets, the common refrain is ‘I’m not worried. I’m still getting the dividends’.
But where are dividends derived from?
Corporate earnings (and in some cheeky cases, from corporate borrowings).
What do low and getting lower interest rates — the RBA’s talking about 0.25% in 2020 — tell us about the economic outlook?
The future is one of sluggish growth…or worse, perhaps there’s a recession coming.
What’s that going to do to corporate earnings?
They’ll fall…taking dividends with them.
The bad times haven’t even hit us yet and we are already being warned about possible cuts to dividends.
As reported in the Australian Financial Review on 7 June 2019:
‘Bank dividends under threat’.
To quote from the article…
‘…those reliant on dividend income [need] to think hard about the longer-term implications of official interest rates being lower for longer.
‘…as official rates set by the Reserve Bank of Australia move to 1 per cent and possibly 0.75 per cent over the next six months, there will be enormous downward pressure on bank profitability.’
Dividends will be cut…
The dividend you’re buying today, may not be what you receive tomorrow.
And it’s not just the banks that are having to make balance sheet adjustments to suit the current climate.
This was the headline from the 30 August 2019 edition of The Sydney Morning Herald:
Source: Sydney Morning Herald
Harvey Norman’s capital raising will help pay down some of the company’s $626 million of debt.
As reported by the Sydney Morning Herald (emphasis is mine):
‘“I’m very conscious of the fact that we’re going to have another recession or depression one day,” Mr Harvey said in an interview with The Sydney Morning Herald and The Age.
‘The retail veteran predicted around 10 to 20 per cent of retailers would go broke in a sizeable recession, and he said he didn’t want Harvey Norman to be one of them.
‘“I can guarantee you that at least 10 per cent of those businesses out there at the moment, and at least 10 per cent of the population, if a recession comes will be in the shit,” he said.’
If, 10% of businesses and 10% of the population find themselves chest-deep in the brown stuff, then rest assured that stench will waft across the rest of the economy.
It’s interesting that Gerry Harvey said ‘another recession or depression’. Was the inclusion of ‘depression’ a slip of his tongue or a deliberate use of the word?
Ray Dalio — the founder of Bridgewater Associates, the world’s most successful hedge fund — has recently written that we’re approaching…
‘The End of the Long-Term Debt Cycle (When Central Banks Are No Longer Effective)’.
The previous long-term debt cycle (that started in 1880) ended in the 1930s…in the midst of The Great Depression. Perhaps, Gerry Harvey’s use of the ‘D’ word was intentional.
Long-term debt cycle last for decades.
The current long-term debt cycle has been in existence since the early 1950s.
Eventually the cycle collapses under the weight of the debt load.
Businesses like banks and Harvey Norman have been huge beneficiaries of the current debt cycle.
The banks have made easy money on their lending margins and retailers have sold ship loads of products to credit addicted consumers.
If, as one of the smartest investors in the world suggests, we’re nearing the end of this long-term debt cycle, corporate profits are going to be adversely impacted.
Which in turn affects dividend payouts.
Bullish pundits will point to the last credit crisis in 2008/09 and say ‘yes there was a modest impact, but things recovered and dividends are much higher than a decade ago’.
But please read the second part of Ray Dalio’s outlook…when central banks are no longer effective.
The so-called recovery since 2008/09 has been artificially created by a globally co-ordinated central bank stimulus effort. We’ve never seen anything like this before. Money printing. Negative rates. Asset price manipulation. It’s been truly unbelievable.
But if, as Dalio states, central banks are going to be rendered impotent in the next crisis, then those expecting an encore performance are going to be seriously disappointed.
Should a recession (one that cannot be arrested by central banks) morph into depression, then the history books provide an insight into what might await investors who relied on the blue chip dividends to remain constant.
The following chart tracks the S&P 500 index (blue line) and the index EPS (earnings per share) (orange line) from 1929–1949.
Source: Macro Trends
Earnings collapsed in sync with the index.
At its lowest point in late 1932, EPS were only one quarter of the October 1929 level.
That’s a rather sobering 75% fall in earnings…caused by the ending of the long-term debt cycle.
It took nearly 20 years before earnings recovered to the 1929 level.
When a share market suffers a fall of 80%, you can be assured there will be economic consequences. People have less money to spend. Less money going through the cash registers means less corporate profits.
If businesses are earning less, guess what happens to dividends?
They are reduced or even, cancelled.
In Barrie A Wigmore’s rather lengthy book The Crash and Its Aftermath: A History of Securities Markets in the United States, 1929-1933 — there’s a treasure trove of data on what happened to shares during the Great Depression.
The following table of US blue chip companies shows the falls they suffered from 1929–1933 and the dividends that were paid in 1933.
Three of the seven ‘blue chip’ companies stopped paying dividends.
The remaining four appeared to be paying a high level of dividends in 1933…but all is not what it seems.
In the case of Gillette, that 13.77% dividend was calculated on a share price that was 95% lower than it was four years earlier.
What do I mean by that?
To keep this exercise simple, we’ll work in whole numbers and assume the company was paying a 4% dividend in 1929.
In dollar terms, the dividend shrank by more than 80%…from $4 per share in 1929 to $0.70 per share in 1933.
This contraction in income is in addition to the share price falling 95% in value. Talk about rubbing salt into an open wound.
In the case of Gillette, cashed up investors could, in 1933, buy 20 shares for the price of one 1929 share…AND receive a 13.77% dividend on those 20 shares.
This example makes a nonsense out of the widely held belief that ‘money in the bank loses its buying power’.
That cash in the bank bought significantly more in 1933 than it did in 1929.
The lesson from 1929 is that when the share market goes through a significant correction, and the economy struggles to respond to stimulus efforts, dividends will be cut…and cut hard.
If you think it’s difficult now to live off a 2% return on 100% of your capital, then what’s life going to be like if both your capital and dividend income is slashed by 50%, 60% or more?
Being in the right asset class at the right time has not been this important since 1929. Choose wisely. Your future depends upon it.
Knowing your market history could pay huge dividends in emotional and financial well-being.
Editor, The Rum Rebellion
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