Miller/Howard Portfolio Management Team Commentary on
Debt Downgrade and Market Volatility
Peering into the Answer Ball
August 9, 2011
Recent market action and events have prompted an energetic verbalizing response from market participants here and abroad. We hesitate to add to the din, but we do have some thoughts on topics we find important.
First, we don’t believe the S&P downgrade is of much importance to the market. That ratings “agency” has had a miserable ten years of pronouncements starting with their AAA rating of Enron and their corrupt similar ratings of the toxic securities that brought down the house in 2008. Too, their statement was no surprise. Indeed, the only surprise was how little actual financial analysis was included. Mainly, it seems they don’t like to see the legislators engaging in heated debate.
Many commentators assured us that a downgrade would lead to higher interest rates. Hah! We don’t think the Chinese are about to shift their savings to Norway any time soon.
Second, this time is different (from 2008). When the stuff hit the fan at that time, financial firms---and many other types---were living on a prayer in terms of historically great levels of leverage. The shock caused by this “leverage implosion” caused a contraction in the availability of capital, and companies began to hoard cash---refusing to raise dividends, and in many cases cutting them. But companies have been busy over the past few years, and balance sheets are in the best shape ever seen by most observers. There is nearly $4 trillion in cash on corporate balance sheets today, a multiple of what it was back then. And banks have capital available, as they have built up reserves to levels not seen since the good old days of Glass-Steagall. It was disarray in the banking system that prompted 2008’s decline, and those problems are not the reality today, as manifested in mild and recently decreasing Libor rates.
Financial conditions for the developed sovereigns may be extremely difficult, but things will improve once they learn to say “we can’t afford it.” Meanwhile business seems to exist in a parallel universe, where debt is under control, revenues are not robust but are adequate, and earnings are flowing as any business owner would want them to. Reporting season is almost over, and the number of CEOs claiming business was bad or visibility was poor was notably small.
This could change. We could have a recession (much of which appears to have been discounted in the past two weeks). But we don’t have one now. Growth may be harder to find than usual, but the steady-state baseline of business belies the current panic in the markets. We are reminded of 1987 (we are old enough to remember it all too well!). The market crashed for other reasons---there are always “reasons”---but business at the fundamental level was doing fine. The seers were sure that the market was “saying” there would be a recession. But the market misspoke. Business remained fine, and the market began to rise within weeks.
Third, technical and sentiment conditions have turned extremely favorable; well beyond merely good. The VIX, a fear gauge, is at a 12-month high. Volume is at a 12-month high, double and triple the 50-day moving average of volume. Oversold readings are at a 12—month high. The number of stocks above their 10-day moving averages is virtually non-existent---an oversold measure almost never seen. Put-call ratios are reaching maximum levels, “risk-on” securities such as energy and commodities are getting hammered as though no one will ever need oil or steel again. Many stocks are reaching PE levels at which they have never sold before (assuming the “e” is for real, of course). Rydex traders are running to the short funds. Our own option open-interest indicator has been losing steam for weeks. Alan Greenspan has said “it [the market] will take quite a while” to stabilize.
These items and many other comparables should be viewed as contrarian indicators. To be sure the short and intermediate-term trend of pricing is down, so chart-technical principles can’t be of much help. But everything that is mean-reverting, from sentiment indicators that have reached extremes of fear, to oscillators and rate-of-change pricing measures that have reached extremes of their own, tells us that from the standpoint of secular market analysis, investors’ eyes should be looking upward now, not downward.
Our own eyes are all about the cash flow from our investments---its sustainability and its potential for growth. For clients that withdraw income, sustainability is paramount. For those who compound company earnings through reinvestment and compounding, income growth potential enters the mix.
We’ve reviewed our companies. We think cash flow is ample to cover the dividends of our stocks, and almost none have a business model that requires substantial refinancing or access to the capital markets, should problems develop there (we’re not expecting this). Debt has been reduced over the last few years. Too, it’s important to note that our stocks generally offer a recurring business model, with products and services that have low susceptibility to the business cycle. Even the MLPs, which do have a greater need for capital markets than many others, are well-financed at the moment and can ride out the storm as they did in 2008. And their business model is one of recurring revenues, as well.
In our view of the world, dividend sustainability is highly important, especially in stressful times, but dividend growth is the key to long-term wealth building. This year; so far so good. Here's how our main strategies have been doing:
|
2011 Declared Dividend Increases* (as of 08/08/2011) |
Yield* (as of 07/31/2011) |
Yield* (as of 08/08/2011) |
Income-Equity Strategy (with MLPs) |
27 |
5.2% |
5.9% |
Income-Equity Strategy (No MLPs) |
19 |
5.0% |
5.7% |
Global Utilities + Infrastructure |
16 |
3.2% |
3.7% |
MLP Strategy |
39 |
6.1% |
7.1% |
Distribution/Merging Utilities |
21 |
3.2% |
4.0% |
Can we keep up the pace if the economy slows markedly? Generally, companies offer dividend increases as a signal from management about future prospects, so we would expect some hesitancy in the event of slowing or recession. On the other hand, businesses are flush with cash, there is pressure from investors to distribute some of that cash, and higher dividend stocks have performed better than the rest recently, providing further incentive for management to increase payouts. If the world of business should get really bad, as in 2008 and early 2009---which, as noted above, we seriously doubt will be the case---we could see some hoarding of cash again, as we did then. Only this time the companies start with large war chests of cash (not with max leverage, as they did then), so “hoarding” is more likely to mean a slowdown in increases rather than cuts.
In Sum
We think the financial system and the condition of business in general is much sounder than it was in 2007-2009. We think if there is a recessionary flavor to things for a while, it will reflect simply a demand slowdown from cautionary sentiment, not the quavering fear that the last recession showed. Market conditions are ripe for a low very soon, we think. But what will ring the bell? You know, they don’t ring bells anymore, they push buttons. What will push the button? A slew of company buy-back announcements would be classic here, or a spate of M&A deals. Technically, an intra-day turnaround on very large volume coming at a logical support point would be the light at the end of the tunnel. Friday looked like it might be that day, but the media flogging of S&P’s announcement neutralized what will buyers could muster. Now the next logical support point is 1120 on the S&P---where it sits as we write.
Dividend Yield Disclosure:This information is intended solely to report on investment strategies as reported by the Investment manager. Opinions and estimates constitute their judgment and are subject to change without notice. Common stocks do not assure dividend payments. Dividends are paid only when declared by an issuer’s board of directors and the amount of any dividend may vary over time. Dividend yield is one component of performance and should not be the only consideration for investment.
NOT FDIC INSURED – MAY LOSE VALUE- ARE NOT BANK GUARANTEED.