This week April 14, 2018, we discuss income investing and the percent of appreciation over time that comes from dividends.
We see why an early warning sign of the Great Financial Crisis, the LIBOR-OIS spread is starting to stir, and why it is not yet a sign of bank stress.
Finally, we revisit blockchain technology.
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Transcript
Welcome to Plus episode 200. It is Saturday morning, April 14, 2018. In this week’s episode, we revisit income investing. We will take a look at a clue to the next financial crisis that, as discussed in episode 155, that is showing some signs of distress, and we look at whether we should be worried or not. Finally, I have a question from a member on blockchain technology.
Income Investing
On income investing, I last looked at this in depth, in the Eclipse edition of the Plus episode. This came between episode 169 and 170. We looked at it in the model portfolios. For example, I don’t have specific dividend-focused ETFs. One question I got this week on income investing is, the recognition of how much have dividends impacted the return of the stock market? Then a follow up question on why there are no high yield bonds right now in the models, and what about other income-focused ETFs?
I pulled up some data from Ned Davis Research that I had not looked at in a while. Comparing the return of stocks with dividends and without. What’s interesting is the straight up returns, this is total annualized return, was 9.7% from … this is for the S&P 500 from December 31st, 1929, through March 31st, 2018, so 9.7%. If we exclude dividends, it was 5.6%. Now that’s roughly a four percentage points difference, and that makes sense because dividends, there was a higher dividend yield in the past.
What’s interesting though is what they did, is, “Well, what if you had invested $100 in 1929 and then continued to reinvest the dividend?” So you’ve got the price appreciation but you are reinvesting the dividend over time. That $100 would’ve grown to $340,280, but if we had just not reinvested the dividends, essentially just took our dividends or excluded dividends all together so we’re not able to reinvest them because we’re not receiving them, it would’ve only grown to $12,312. So a dollar investment of $100, 96% of the return on a dollar basis was from dividends.
Now, we can look at that over other periods, so let’s just look at the last 10 years. So let’s see, here I’m looking at this table. So let’s go from 12/31/2009 through 3/31/2018. Total return, including dividends, was 13.2%. Without dividends is was 11%, which makes sense because the dividend yield has been roughly 2%. That $100 invested in 2009, if you collected the dividend reinvested, would’ve grown to $279. If we took out the dividend, didn’t include it, it would’ve grown to $237, so about 15% over the most recent decades was from dividends.
If you go back 20 years, it’s about 29% of the appreciation is from dividends, and the further back in time you go, the more dividends have an impact on the total return. Now when we talk about income investing, we are collecting a dividend. We continue to collect the, roughly, what? In terms of the US stocks, is about a 2% dividend yield. Global stocks, it’s roughly, I believe, 2.4% dividend yield. So when we talk about income investing, we talk about what are the merits of actually investing in an ETF that emphasizes dividends.
Just another statistic, 30% of US stocks now have dividend yields greater than 10-year Treasury Bonds. That was 65% back in 2016. So as interest rates have gone up over the last several years, you’ve not seen, necessarily, a rise in the dividend yield, so less stocks pay a yield greater than the 10-year treasuries.
Now, what we need to look at is what are the merits of investing in a dividend strategy? We know that a higher dividend, over time, will, if you’re a long-term investor, will allow for greater return, but that’s just stocks without dividends. When we look at actual dividend strategies, one of the important thing to look at is what is the valuation, because a lot of money has moved into dividend strategies and as a result, dividend yields have dropped and their valuation relative to, let’s say, dividend growers, which are companies that might not have as high a dividend yield. But they’re growing those dividends faster, the bottom line is the valuation for dividend yield strategies are high right now.
The overall US stock market’s high, but specifically, particularly dividend yield strategies have a higher valuation which could, if prices compress a little bit into where dividend strategies become less over-valued, then that actually could lead to under-performance of dividend strategies over future years.
But let’s just look at it. So high dividend yielders, the median dividend yield for a high dividend yielding strategies, this is US stocks, is about 3.6%. That’s the dividend yield. So you pick up about 1.4% or 1.6% more than just a straight US stock investment. But the average for high dividend yielders going back to 1975 was 6%, and it was over 8% in 2009. Going in to high dividend yield strategies in early 2009 was an extremely compelling investment. It was near its historic lows in terms of that 8% dividend yield, but now that 3.6% dividend yield relative to the 6% average, we’re about 1.1 standard deviations out of the norm. In other words, the dividend yield is much lower than what it has historically been, so it’s not as an attractive time to invest.
Compare that to high dividend growers, those that are growing their dividends faster, that median dividend yields 1.6%, so lower than the overall stock market. The average has been 2.3%, the median dividend yield for dividend growers, and so it’s only about 0.8 standard deviations off from that average.
Now when we look at the valuation in terms of the forward price to earnings ratio for high dividend growers versus high dividend yielders, high dividend yielders are about 1.5 standard deviations more expensive than they historically have been relative to high dividend growers. So when it comes to the models in terms of dividend strategies, I think it’s a valid strategy but because, one, the US stock market is expensive overall, we’ve de-emphasized that. Dividend yield strategies, because they become so popular, their valuations are higher than they have historically been, so I don’t find it compelling necessarily to overweight or emphasize that currently. There could be a time where we talk about that in more detail.
A Continued Look at Dividends
Now, back in the August episode, again, the Eclipse Plus episode, I provided more historical performance of high dividend strategies versus other strategies. Then the member asked about regarding high yield non-investment grade bond strategies, that when we talk about income, it’s not necessarily always dividends. In that case, again, they’re not compelling right now. When we looked at forward expected return, high yield bonds are yielding 6.2%, but they have defaults every year. So, if we assume average annual defaults of 4%, which is what they’ve been, and when a high yield bond defaults, you don’t lose all the money. There’s typically some recovery, so typically 60% of the principal is lost, 40% is recovered.
So when I update the 10-year return assumptions for high yield bonds, I always start with the current yield to maturity, and then back out an assumption for default and recovery. So based on a 4% annual default and a 40% recovery, that reduces the expected return by about 2.4% a year. If the yield’s 6.2%, we’re backing out 2.4% overall on terms for defaults, that brings the expected return down to only about 3.8%, so it’s a low expected return.
Now, the other way we look at that is well, what is the yield, the incremental yield we’re getting with high yield bonds relative to 10-year treasuries? The incremental yield, and we show this monthly in the investment conditions report, is 3.3%. So you get additional 3.3% with high yield bonds above 10-year treasuries. The average, going back to I believe the mid-1970s, is 4.9%. The time to invest in high yield was back in April 2016, for example, when we actually began the model portfolios. In that case, the yield advantage was over, I think it was almost 5 and a half to 6%. I’d have to double check that, but it’s better to go into high yield when they yield spreads are wider than normal, to provide a margin of safety.
Now, that’s not to say that high yields are going to do terrible over the next few years. We really need a recession. When the risk of a recession increases, that’s when you see the spreads balloon out. Typically high yield bonds, they’re not in the model. We took them out in April 2017 because the spreads had gotten so narrow and you just weren’t being compensated for it, the default risk. So, again, income strategies are good but it depends on valuations. We have some other income strategies, bank loans for example are an income strategy in the model portfolios, real estate investment trusts. So I tend to be an opportunistic investor, a longer term opportunistic investor, but I want to add something when the valuation is more compelling.
In episode 155 of the podcast, it was titled Clues To The Next Financial Crisis. I talked about how this measure, somewhat of a complicated measure, in fact, every time I do an episode on it I have to look up the definition again. It’s the London Interbank Offered Rate. London Interbank Offered Rate, LIBOR, which you might have heard of, that’s one measure. The other is the Overnight Index Swap, OIS for short. So we’re talking about the difference in the yield between LIBOR and OIS, that’s why we talk about the LIBOR-OIS spread.
Now, this Overnight Index Swap, essentially is a proxy for very short, risk-free interest rates, so overnight loans through coordinating with the Federal Reserves, so essentially the Fed funds rate. So it’s, an example, a very short term effectively risk-free lending. LIBOR is a measure of interest rates that banks charge to each other for unsecured loans. So in the great financial crisis leading up to it, the LIBOR-OIS rate got as high … It went over 3%. It began to, in 2007, reach close to 1%, then it got over 3%. It was a sign that banks didn’t trust each other, that they weren’t lending to each other and it was a pre-cursor for basically all the things that ensued that we’ve talked about in episodes.
Now though, so in episode 155, I said that’s a measure we should keep an eye on to see if it widens again, and it is. It’s up to 0.6%. It’s generally been, in the last year, around 0.2%, that’s what it averaged in 2017. At year end it was at 0.27%, and not it’s at 0.6% or over 60 basis points. So then the logical question is should we be concerned? Is this sign a sign of some bank stress?
It turns out that Joe Kalish, he is an analyst or the Head Fixed Income Strategist at Ned Davis Research. He did some work on this to figure out what’s causing it. I’ve seen other reports that corroborate what he says. But more than a third of that increase, that 60 basis points, is due to just the supply of new treasuries. With the debt limit suspended, the Treasury department, they had a backlog of treasuries they needed to issue. There’s been a big jump in short term treasury bills, and that tends to actually push up yields because there’s more supply of bonds and other investment opportunities. There was a chart that I saw where there’s actually fairly high correlation. As new treasury bills come online, that LIBOR-OIS spread tends to widen for whatever reason, so that seems to be one issue.
The other is that there is some credit risk issues in conjunction with the new tax code and, frankly, as I read these explanations, this is such an arcane measure that I have to pause and think about it. So, this is just a little challenging to understand, even for me, but the Wall Street Journal reported that US branches of foreign banks that have relied on short term borrowing from their headquarters overseas, now as they borrow from other overseas branches, apparently that that borrowing is now taxable. That has induced some additional risk into this system and that somehow is reflecting in higher LIBOR-OIS spreads.
Then Kalish determines that less than 10% is actually due to the widening of LIBOR. In other words, we now have 0.6% in terms of that overall spread, only about 10%, so what, 6 basis points, is due to concern regarding banks lending to each other on a short -term basis. So there does not appear to be stress in the system right now. There seems to be supply factors, some credit factors a lot to do either with the debt ceiling or with the new tax code, and so let me leave it at that. It’s really complicated. I should’ve put that one at as the last topic.
Blockchain
All right, so a member asked regarding the blockchain. Particularly, as you know, I’ve done episodes on cryptocurrencies. He attended a conference in which Tim Draper spoke. Now Tim Draper ran a hedge fund, I believe he still runs a hedge fund. In 2014, he bought 30,000 Bitcoins for less than $20 million. I don’t know if he took it within his hedge fund or personally, but he bought a bunch of Bitcoin. That’s now worth almost $215 million. He is very much a Bitcoin advocate, and here was his quote. “In five years, if you try to use fiat currency, they will laugh at you.” Now, what he was implying is fiat currency is going to be replaced by cryptocurrency. That brought this question from the member in terms of my view, in terms of the underlying value of the blockchain.
Now, by blockchain, all we mean, at least my definition, is all these cryptocurrencies, they’re essentially spreadsheets in the sky. They’re accounting books that record all the transactions that have occurred, and we have participants, miners is what they are called, that are verifying all these transactions, verifying that this accounting book in the sky, this spreadsheet, this ledger of transactions is accurate. So it’s this distributed validation, proof of work that the ledger is correct. That’s what the blockchain is.
Now, different types of cryptocurrencies potentially can add additional smart contracts with things related to the blockchain, but that’s what it is and it is revolutionary, but when I look at how it’s developed, it depends … a blockchain is effective if you have this distributed proof of work. The only reason that this exists is that there’s a reward for doing the work, in terms of getting new cryptocurrencies and some transaction fees. So when we talk about all these different blockchain technologies, it is dependent on owners of computer networks wanting to participate and validate and do some work that costs money in terms of computing power, resources, time. So there’s almost a network effect, which is why I like Bitcoin because it has been around, it has the network of miners that want to validate the transaction. It seems to have trust, but most holders of Bitcoin are not using it to buy things. They’re using it to store value, it’s a form of digital gold. I don’t see how that changes.
I would not use Bitcoin to buy something, because Bitcoin, there’s a set number of Bitcoin, 21 million I believe is the number that will ever be issued, which means Bitcoin is inherently deflationary. The value of Bitcoin, as long as there continues to be trust in it, will continue to increase relative to the dollar, because the dollars are created every year through bank lending, so there is an unlimited supply. Whereas, there is not an unlimited supply of Bitcoin or other cryptocurrencies. So in order to want to use that for a transaction, you don’t want to be using a cryptocurrency that will continue to increase in value relative to a dollar, which means that if you buy that pizza 10 years ago in Bitcoin, that value of that Bitcoin today in dollars is extraordinarily much, much higher. That’s what I mean by deflationary, that you’re able to more and more with Bitcoin over time, and that doesn’t make for a good fiat currency.
So that’s just some view on that, I think maybe I just don’t get that excited over blockchain. I think it’s interesting, it’s intriguing, but I’m not investing in every blockchain startup that comes along. I own Bitcoin, and I own some Ethereum and Litecoin, smaller amounts, but again when it comes to these strategies, this is a hedge against inflation, against other things. It’s speculation, pure speculation. It could go to zero, and I invest a proportional amount that if for whatever reason people just didn’t care anymore and stopped using Bitcoin then I would be fine, so I’m not staking my retirement by any means on Bitcoin. So that is Plus episode 200.
