Fagan Associates Archive for August, 2010

Nearly two years ago, October 2008, Standard & Poor’s published results of a study that went back several decades and examined the impact that stock dividends had on total return (dividends +/- capital appreciation/depreciation) as well as stock price stability.  Although not surprising, the results did illustrate the value of dividends as they pertain to total return and share price stability.  As of this writing, with the ten-year U.S. Treasury Note hovering somewhere near 2½ % forcing investors to look for alternatives, we thought now would be a good time to examine the impact of dividends on total return.  Some of these findings are detailed below:

“From August 1989 to September 2008, dividends contributed approximately 28% of the total equity return of the S&P BMI World Index, while price appreciation contributed roughly 72%.”  However, “from August 199 to September 2008, dividend income accounted for as much as 52.05% of total return.”  It is important to note that the timeframe referenced immediately above occurred during a period of time when the stock market was relatively flat.

The study notes further that “in addition to providing a steady source of income for investors, dividends also play another important role during periods of volatility.  While price returns can be either positive or negative, dividend incomes are by definition positive.  This provides a cushion during negative equity markets….  Not only are dividends positive, they are relatively stable through time.  Wide swings in stock prices can be partly attributed to speculation and market sentiment; whereas dividend income, as a component of a company’s earnings, is less subject to speculation.”  In fact a study done by Fuller and Goldstein (2004) “examined the return behavior of dividend paying and non-dividend paying firms in both up and down markets, from January 1970 to December 2000.  The authors found that dividend-paying firms outperformed non-dividend paying firms more in down markets than they did in up markets.  Therefore, dividends allow investors to capture the upside potential while providing downside protection in negative markets.”

What’s an investor to conclude from this information?  We suggest that should your financial objectives allow for some allocation to the stock market, dividend paying stocks and dividend paying stock mutual funds represent an attractive alternative to fixed-income investments, including Certificates of Deposit and Money Market Accounts.

Investors looking for dividend income must first determine whether or not they can expect the dividends to continue at least at their current level.  A relatively simple way would be to calculate the current annualized dividend as a percentage of total earnings from operations.  For most companies, dividends should be no more than sixty percent of normalized earnings while for regulated utilities, this percentage can be as high as eighty.  For even more security, calculate this percentage for the past five years.  This will give you a clearer picture of the potential for a continuation of the dividends.

For accounts that can accept the risk of equity investing, we would consider Altria Group (MO); Conoco Phillips (COP); Darden Restaurants (DRI); Abbott Labs (ABT); the Jensen Fund (JENSX) and the Vanguard Wellington Fund (VWELX) which carry dividend yields of 6.1%, 4.1%, 3.1%, 3.5%, 1.04% and 3.02%, respectively.

THE BOTTOM LINE – With interest rates at multi-decade lows as a result of this “once in a lifetime bull market in bonds,” investors with a time horizon of more than five years might be wise to consider alternatives to Bonds, Certificates of Deposit, Annuities and Money Markets.  Stocks with dividends can provide investors with more income than many bonds, but with some added risks.

Compare and contrast the tenor of the statement released by the Federal Reserve after the most recent meeting of its’ Open Market Committee (FOMC) this past Tuesday with the prior one released June 23^rd as well as comments from John Chambers, the CEO of tech bellwether Cisco Systems, after it reported quarterly earnings this past Wednesday with those from the prior quarter and it becomes evident that there has been a marked slowdown in the pace of economic growth coupled with an acceleration in uncertainty over where the economy is headed.

Consider how Press Release dated June 23^rd.  The Fed begins “information received since the Federal Open Market Committee met in April suggests that the economic recovery is proceeding and that the labor market is improving gradually.”  Further down within the same release the FOMC states that it “anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be moderate for a time.”

Flash forward to the statement released this past Tuesday.  This time the Fed begins with “information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months.  Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.”  Further down in the statement the Fed notes that due to “low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”  Finally, to support this objective the Federal Reserve will now “keep constant the Federal Reserve’s holdings of securities at their current levels by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.”

Equally cautious but candid comments were echoed by John Chambers on the quarterly conference call centering on their earnings.  Chambers observes that “we are seeing a large number of mixed signals in both the market and from our customers’ expectations, and we think the words ‘unusual uncertainty’ are an accurate description of what is occurring.  The Federal Reserve’ s comments yesterday that the pace and output of the recovery has slowed in recent months, and that the recovery is likely to be more modest in the near term than had been anticipated just a few months ago, are comments that most of our large customers that I have talked with recently would agree with.”

Compare this with a statement made by Mr. Chambers on May 12^th within their prior quarter earnings.  “Our financial results were outstanding, achieving record level revenue and earnings per share results.  We witnessed a return to strong balanced growth across geographies, products and customer segments that we haven’t seen since before the global economic challenges began.”

This cautionary tone expressed by both the FOMC and Cisco is part of the reason that stocks are having a tough time breaking out of their recent trading range, a range that we believe will be around until the mid-term elections.

THE BOTTOM LINE –If we are right and we are stuck in a trading range and as we mentioned in the past, look to add to your mutual funds down around the “Flash Crash” panic lows of May sixth of around 9,756 on the Dow.  Other than that keep some cash on the sidelines and await a better opportunity.  We believe this will come before the end of the year and will ultimately close out calendar year 2010 with mid to upper single digit gains in the major indices.

Regular readers of our column recognize that every once and awhile some issues not sufficient enough to comprise an entire article accumulate so we put together a “hodge-podge” like column.  Like other times when we have done this, some of these topics provide little tidbits of insight while others are profound.  Enjoy.

Not surprisingly, according to a study completed back in 2006 by Professors Michael Ferguson of the University of Cincinnati and Hugh Douglas White of the University of Missouri and related in an article by Mark Hulbert, “the Dow between 1897 and 2004 produced an annualized return of 5.3% when Congress was out of session, in contrast to just 0.4% when it was in session.”  Why does this occur?  Within the study completed by the two professors and noted in Hulbert’s article is a quote in 1930 from Will Rogers.  “This country has come to feel the same when Congress is in session as we do when a baby gets hold of the hammer.  It’s just a question or how much damage he can do with it before we take it away from him.”  Enough said.

Continuing along the topic of how markets historically respond to politics, when examining the four-year Presidential Election Cycle, according to SeasonalCharts.com, this year, the Midterm Election Year, the stock market has provided little or no return.  Furthermore, any return that is realized typically comes during the fourth quarter.  It makes sense.  Presidential Administrations, no matter which side of the aisle, initiate programs, reforms and push forth policies that typically come to a head during this year.  This year is no different.  Consider the Cap and Trade Energy Policy, Health Care Reform, Financial Regulation and the push for higher Personal Income Tax Rates.  Thus far this year, this has resulted in a flat stock market.  Case in point, year-to-date, through the end of July the Dow Jones Industrial Average has risen just 0.36% while the index that provides the broadest look at stocks, the Wilshire 5000 Total Market Index has fallen 0.04%.  Despite this lackluster performance, we are holding on to our outlook for the stock market which we first presented in writing within our Q1 2010 newsletter, The Fagan Financial Report, that “stocks move in fits and starts, but end the year modestly higher, perhaps by high single digits.”  We are expecting that a reestablishment of the balance of power in our elected offices, much like the 1994 mid-term election, could provide the catalyst for a year-end push higher.

Topic number two.  Since the Dow Jones Industrial Average was first introduced back in 1896, the months of July and December have provided the greatest average returns logging gains of 1.4% per month.  However this is closely followed by the month of August with an average of 1.3%.  That said, then why don’t investors continue to pile into the stock market at this time?  The reason is clear.  The month of September provides the worst return with the Dow falling an average of 1.2%.

THE BOTTOM LINE – Usually when a statistically anomaly becomes widely accepted it fails to provide any guidance.  We don’t use any one particular statistic as gospel.  However, we do take all rational ones into consideration when investing client portfolios.  We hope this article will help you.

It is more often that you hear or read of reasons to convert from a Traditional IRA to a Roth IRA than you hear or read of reasons not to convert.  Given the fact that this column pertains to the latter, we will only briefly note the reasons to convert.  These include the potential for rising personal income tax rates, tax free withdrawals after five years from a Roth and no mandatory distributions.  That said, there are several reasons why one should not convert from a Traditional to a Roth IRA.

First and foremost, a bird in the hand is worth two in the bush.  When you convert from a Traditional to a Roth IRA, you must pay the tax on the conversion immediately.  This has two negative consequences, the first being that you are paying those taxes from retirement savings thereby reducing those savings and secondly that the tax money is now in the pocket of the Internal Revenue Service rather than continuing to work for you.

One must also keep in mind that the dollar amount that is converted is added to your current income and taxed as ordinary income, which for most of us is at a federal rate of 28%.  This added income may push you into a higher tax bracket or cause your Social Security Benefits to become taxable, if you are currently collecting.

Another reason not to convert is that for many of us, our tax bracket during retirement may be lower than our tax bracket while working.  If you convert during your higher income earning years, you will most likely lose 28% to the IRS.  However, there is a fair chance that in retirement you may be in a lower tax bracket, perhaps 15%.  Therefore, why pay 28% now when you can pay 15% later?

Current law states that an individual may begin to withdraw from your Traditional IRA without penalty after you turn age 59½, but that you must begin to make withdrawals on or before April 15 following the year the individual turns 70½.  For some of our clients, we are able to make calculated withdrawals between these dates in such an amount that will keep the client in a low tax bracket.  This is another reason not to convert while you are in a high income tax bracket.

We like to turn the tables on those that recommend conversion due to the fact that with Federal and State budget deficits at alarmingly high levels, higher personal income tax rates are a fait accompli.  Although we do believe that marginal rates will rise, we do not consider it a done deal nor do we believe that they will rise substantially for the middle class.

With the tidal wave of baby boomers set to retire and thus set to begin to live on their savings, pensions and Social Security, we believe the Federal Government through the IRS will begin to explore different methods of taxation as a supplement to the personal income tax.  These alternatives include a flat tax, a value added tax (VAT), consumption tax or a national sales tax.  This may result in personal income tax rates remaining at or near where they are now with the added revenue coming one or more of these four sources noted immediately above.

Finally, although somewhat remote and given the wave of baby boomers nearing retirement, we would not be surprised should the government eventually tax distributions from Roth IRAs should the income or assets of the taxpayer exceed a certain level, a la Social Security.  “Somewhat” remote, but not that unlikely.  Think about it.

THE BOTTOM LINE – Think twice prior to converting from a Traditional to a Roth IRA.  As noted above, a bird in the hand is worth two in the bush.  Why pay taxes now when you can pay them later.