Tuesday, September 21, 2010

Dividend Investing in an Uncertain Economic Climate

Guest Post by Vincenzo Desroches

The economic recovery in the United States is hitting a major wall of resistance. In early 2010, the recovery seemed to be doing quite well. Unemployment was falling, retail sales were increasing, and economic growth as measured by GDP was expanding. It all seemed so rosy.

But when the European Debt Crisis fully erupted in the spring, the global economic recovery began to show signs of faltering. Then in June and July, key economic data out of the United States disappointed to the downside quite strongly. By mid-June it became very clear the U.S. recovery was in trouble, and in late July Federal Reserve Chairman Ben Bernanke basically sealed the deal and removed all doubt from the market when he stated before Congress that the economic outlook for the United States in the 2nd half of 2010 is “unusually uncertain.” It was official—the Federal Reserve had no clue how bad things were going to get.

Then, the Federal Reserve resumed talks of possible further quantitative easing measures, and they downgraded U.S. growth prospects substantially. Growth prospects for the 2nd half of 2010 are now expected to be under 2%. That low of a growth rate makes it basically impossible to reduce unemployment. The best scenario for the United States is that we will enter into a multi-year period of very sluggish growth. Unfortunately, that seems to be the best case scenario. It seems very possible that the United States could slip back into recession in the coming 12 months. Although this scenario is not likely at the moment, it is possible. The most probable picture is an extended period of slow growth, but a complete melt-down and recession is definitely possible.

Therefore, in these extremely uncertain economic conditions, many investors are puzzled as to how or if they should partake in dividend investing. In 2008 and 2009, dividend investing took a huge hit. During Q4 of 2008, 288 companies cut dividend payouts and in 2009 another 804 companies cut dividend payouts. The estimated cost to investors was $58 billion. The reason companies cut dividends was simple—they needed cash. During a recession, credit markets tend to tighten significantly and companies do not want to risk an inability to access cash. Thus, they cut the dividend payout in order to bolster cash reserves.

Mr. Bernanke testified in July that the state of credit markets was less than optimal for business expansion and he addressed the fact that companies are still having a very hard time accessing the credit they need to expand and conduct business. This concern may be exacerbated by the current economic slow-down, and credit markets could be headed for even tighter conditions though the 2nd half of 2010 and into 2011. This fear of tight credit markets may cause more companies to cut dividends in the coming year.

Consequently, in an uncertain economic environment such as this, how does an investor approach dividend investing? First of all, investors should be cautious of chasing high yields. Instead, during times of economic uncertainty, it may be better to stick with companies that are in line with the broader market average of 2-4%. Second of all, focus on cash. Cash is king during times of recession and slow growth, so make sure the company has a healthy cashflow. And finally, make sure you diversify across the broader market by investing companies in all major sectors. You may want to consider limiting your exposure to the financials as they may face a very difficult year. Diversification will help ensure that you are at least partially exposed to the sectors that do show strong growth over the next year. foreign exchange trading is another way to diversify outside of equities that could help hedge against poor stock market performance. Using a forex demo account is a good way to get started.

1 comment:

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