Market fearI have not been writing a lot this summer because we know you were busy enjoying the amazing sunshine we have been having.  We sure have been busy too, keeping abreast of market developments even if things have been fairly stable and positive.

Specifically, we have been evaluating where this market is going.  Many of you have been asking whether some actions are required after such a strong market recovery.  Is it time to sell?  Should we be reducing exposure to equity?  Are we heading for a crash?  These are the kind of questions I get every day. Honestly, I too ask myself the same questions.

Here is a brief summary of our analysis:

The markets will likely continue to go up because of four main factors:

1.      External Liquidity

Even though the U.S. Federal Reserve is reducing Quantitative easing, it’s still putting money into the system and it’s still a few months away from withdrawing liquidity and raising rates. That external liquidity tends to drive stocks.

2.      Internal Liquidity

Companies balance sheets still holds lots of cash and there has been an increase of capital within investors cash holdings. But, as the Fed tapers, there will likely be a movement of cash from retail investors as they move towards stocks.

3.      Cheap valuations

This is a tough one but valuation metrics appear to be fine, relative to historic mediums and means.  Equities are cheap relative to interest rates.  We think that equities and interest rates have to rise a lot more in order to correct the major undervaluation relative to interest rates.

4.      Global stability

The U.S. economy is improving. At the same time, China has the monetary and fiscal policy firepower to ensure a soft landing. Europe has bottomed. We are in a sweet spot we feel.

What if we are wrong?

Well, even if we are wrong, it does not matter.  What?!  Of course, when the markets drop you also see a drop in the market value of your account but you keep getting your dividends.  In good and bad times, there are dividends.

A dividend is a payment made by a corporation to its shareholders, usually as a distribution of profits.  Dividends are like rent income for a rental property.  The market value of your real estate might go down but your rent will stay the same.  Of course, nor dividends or rent cheques are guaranteed.  This is just a basic analogy to illustrate that historically even when the stock markets drop, mosts dividends will continue to be paid.

Warren Buffet calls dividend paying stocks, Equity Bonds.

Investors and especially retirees need not only income, but also cost of living adjustments (known as COLA). Otherwise, inflation can erode their purchasing power as the years go on.

Dividends are very important and the investor’s best friend mainly, because with time they rise, and keep up with inflation.  When we have inflation, the price of goods and services go up.  The companies that deliver these goods or services are making more money and will in turn pay more dividends.  If you invest in bonds or GICs, the purchasing power of your interest will go down when we have inflation but if you hold equities, you will own dividends which rise with inflation.  Dividends are you best friend over time.

If you are retired and fortunate enough to derive income from a pension, the cost of living adjustment can still be a sore subject because they are rarely guaranteed.  Even with the government pension, you may be subject to politicians’ whims on how much of an annual increase, if any, you can expect.

But an increasing number of retirees don’t have traditional pensions and must rely on a combination of investment income, RRSP savings and government pensions.

Therefore, even if equities are volatile with market sentiments, they are your best ally over time to counter inflation.  You should hold equities at all times regardless of where the market is heading.

Relying on dividend figures alone is not enough however. You must do additional research to make sure the company can comfortably support the dividend from its cash flow, and then go further and consider whether the firm is in a position to increase its dividend.

That is precisely why we rely on our dividend fund managers to research and identify companies with ability to continue paying dividends and or even raise them.  Free cash flow yield is often talked about. Free cash flow is a company’s remaining cash flow after capital expenditures. The free cash flow yield is free cash flow divided by market capitalization.  Analysts look at the difference between the dividend yield and the free cash flow dividend. The greater the difference, the easier it is for a company to raise dividends.

Like I say often, always remember that equity investment returns are closely tied to corporate earnings growth and the price you pay for those earnings. Historically, over the long term corporate earnings have been fairly stable and have grown along with productivity gains and inflation. Stock valuations though are more volatile than earnings since they are influenced by investor sentiment, which swings between optimism and pessimism.

Some will say that this view is optimistic.  I would say that this view is realistic.  A rational optimist is usually a successful investor.  Over the long term, and if we need money until age 90 or more, we sure are in for the long term, we need an adequate portion of our investments in equities to meet and exceed inflation.  Staying invested in good quality income investments will protect your lifestyle and peace of mind.