The dilemma for anybody who wants to sock away some money in an off-farm investment is finding a balance between safety and return. These days it’s tough, for returns on bonds are low single digits at best and returns on stocks are not likely to be much more than four per cent on a safe dividend plus any capital appreciation you can get.
If a stock with a solid dividend — and these tend to be big companies that because of their very size cannot grow very quickly — adds a few per cent to its price in the next year, that will be a pretty good performance. In the end, you have to balance solid corporate bonds at four to six per cent (higher than this and you are into junk territory) with a stock that for the next year will provide a four to five per cent dividend plus any price appreciation. Outside of registered accounts, such as RRSPs and TFSAs, dividends generate a tax credit that boosts their pretax equivalent by about 28 per cent. But the stock is going to be much more volatile than the bond. Adjusted for risk, the bond and the stock return about the same thing.
Bond returns tend to be very influential in setting stock returns. That’s because big institutional bond investors who buy government bonds listen to the macroeconomic murmurs of their economies very closely. And in the U.S., which is quite influential in setting the mood of the Canadian bond market, the mood is very glum.
Jack A. Ablin, chief investment officer of Harris Private Bank in Chicago, a unit of the Bank of Montreal, says that the expectations for interest rate gains in the U.S. are very low. The 10-year U.S. Treasury bond, which is a bellwether for world bond markets, rose an astonishing 16 per cent from January 1 to Oct. 13, 2010, leaving the yield to maturity at 2.56 per cent. That low yield is what investors are now prepared to accept in order to be free of what they regard as excess risk. At that rate, it would take 28 years for money to double even before deflating the return for inflation and taxes. After all that, the real return is zero or even negative.
So we come to the essential question— what kind of chances do you want to take? Bond interest rates are probably as low as they can get. The Bank of Canada has put off more short-term rate increases for a while and the U.S. Federal Reserve Board, stuck with short-term interest rates of 0.25 per cent, is just pumping money into the market. At these low yields, bond risk is high. When interest rates do rise, existing bonds will fall in price. That’s because their low coupon yields won’t be very appealing compared to new bonds with higher interest rates.
On a short-term basis, stocks look pretty good. The S&P/ TSX index rose 8.7 per cent in September, a very good return for an uncertain market. The stock market is ignoring the possibility of the long-term stagnation that has held Japan in a vise of deflation for the last 20 years. The stock market can look at Canada’s relationship with China, assume that Chinese growth will translate into demand for coal and copper, wheat and potash. Even a slowing of the Chinese rate of growth would still leave the country in a boom condition. Canada has to benefit from that is what stock investors seem to be saying.
What is an investor to do? The world economy will recover, though it may take a few years. In the meantime, the conservative investor can buy stocks that pay solid and rising dividends. Chartered banks, public utilities, senior telecom companies like BCE Inc. and Rogers, and a few integrated oils qualify. There are risks; banks are leveraged lenders and can be devastated if a bad economy raises loan losses above provisions they have made for loan losses. Telecoms are always at risk of becoming obsolete by the next twist of technology. Public utilities are the mercy of their regulators. And oil companies are ultimately at the mercy of the price of crude, world demand, and regulatory pressures. In short, good dividends are not a free ride. I’d bet on banks and utilities being the best dividend payers.
The conventional wisdom in a time of uncertainty is to straddle the fence. Buy stocks that pay handsome and supportable dividends and convertible bonds, which are much the same thing, though far more complex. As bonds, they pay a little less than a similar non-convertible issue, but in a good economy, they may convert to stocks that may pay a rising dividend and offer hope of capital gains.
The unconventional wisdom is to be brave and take a stand. The choices are be bullish. That means purchase stocks or equity funds and wait for good economic news to take the market or the funds units to a higher level. The alternative is to be bearish and short the market or purchase a bear fund — they are available for gold, oil, the S&P 500 and the TSX/S&P Index— and wait for bad news to sink stocks or the sector in question.
I have no inside track on the future. But the bet for and against the market or a sector is neither equal nor fair. When you bet on an asset rising, the most you can lose is 100 per cent of what you have invested. When you short the market, a stock or a sector, your potential loss is infinite. That’s because you have bet against something rising infinitely high. When you own a sector or the market, you may get dividends. So the odds are with the long play and they get better if you get period income via dividends or bond interest. Moreover, if you own the stock or an index, you can write covered calls, that is, give others the right to buy your stock or shares of an exchange traded fund in exchange for some premium income. My friend andGrainewscolumnist, Andy Sirski, makes a good living from this practice.
Much money has been made in the past by being a contrarian. In the present market it is hard to know what to bet against. The bond market says worse is to come, even if the stock market toys with the idea of sustainable recovery. But even in stocks, the fashion of the moment is stocks with strong dividends. I think that, for now, it is wise to shun risk, to go with the masses and buy mature companies with many lines of business, strong balance sheets and dependable and even rising dividends. This is one market in which the brave, rather than being winners, stand to get slaughtered.
AndrewAllentuck’slatestbook,WhenCan IRetire?PlanningYourFinancialLifeAfter Work,willbepublishedinapaperback editionbyPenguinCanadainJanuary,2011