Stockwatch: Time for dividend health check

Is the stockmarket drop starting to look rational and anticipating a profits downturn? In these macro pieces I've made the chief risks plain: market values inflated by loose monetary policy, versus spreading deflation and record global debt.

The US Federal Reserve, the most important central bank for global sentiment, has abandoned quantitative easing (QE) and wants to normalise interest rates. Martin Feldstein, the veteran Harvard economist, argues the Fed should continue with gradual rate rises and not worry about stockmarket falls; the US market became 30% overvalued on earnings anyway.

Against this risk, equities will still get bought - especially where they offer sound yields of 4% or better, as rival assets won't return much even when rates do rise. But I've also argued the buck stops with company profits, also as evidence of whether the extraordinary stimulus since 2009 has had much lasting effect. This is significant also as regards fresh hints of QE from the European Central Bank (ECB), and whether they really are a credible defence against downturn.

Last November I cited how the consultancy group EY had tallied, for third-quarter 2015, the biggest rise in profit warnings for four years, with 79 - or 5.6% - of UK quoted companies warning, the highest percentage for that quarter since the 2008 crisis.

I asked then: "To what extent might this reflect a general turn in the cycle - already long, if you include the trough of 2009 - or is it a snapshot during an unstable recovery from the great recession?" Yes, there are disruptive effects currently and "headwinds" are a fashionable excuse among companies, but let's keep in mind whether any wider trend is underway.

Alarm bells in latest indicators

EY has now declared that the fourth quarter of 2015 saw 100 profit warnings - 7.3% of UK quoted companies - with a median share price fall of just under 14%, the highest quarterly total since 2009.

The total number of profit warnings only edged up to 313 from 299 in 2014, but the quarterly context is significant. Not surprisingly, half of all FTSE oil equipment, services and distribution companies issued warnings last year. However, warnings in this fourth-quarter survey are quite broad-based, e.g. support services (16 warnings), electronic & electrical equipment (seven), general retailers (seven), media (six) and travel & leisure (six).

Some of this may indeed reflect disruptive factors, e.g. the oil price drop on services to that industry, the internet changing media and retail and terrorism fears affecting travel. But these sectors are also good indicators of any broader cycle.

Interestingly, there was a 27 January caution from Creston, the marketing communications company, which said that "in the first few weeks of 2016 the group has been advised by a number of clients, across multiple-industry sectors, of project delays and cuts.

"Some of these relate to client-specific circumstances and others are due to increasing concerns that some of our clients have about the trading outlook for their businesses, given the current uncertainty in the global economy".

Disruptive influences are, therefore, morphing into wider concerns. George Osborne's New Year message that 2016 looks like serving up a "dangerous cocktail" becomes more understandable and, given his change of face since the autumn statement, it begs the question: "What else might he know?"

How far can this slowdown spread?

It's well-known that manufacturing is having a hard time globally (some economists would call it a sign of secular stagnation), while consumer confidence has generally held up (partly due to the wealth-effect of QE boosting asset prices). In Britain it has had to cope with the recent strength of sterling hampering exports.

Reduced demand from China, whose debt-funded infrastructure boom helped rescue the global economy post-2008, implies an over-capacity, or over-stocking, issue which needs time to re-balance, i.e. primarily affecting raw materials and related industrial services. The loss of British steel-workers' jobs exemplifies the knock-on effects.

Recently, the sense has been that they amount to a demand-shock type of recession afflicting the resources, manufacturing and companies serving them. But if the negativity continues then it can spread elsewhere - for example to retail - which is why the EY survey and Creston caution are perturbing. It will, therefore, be critical to keep a close watch on company updates.

Hedge funds imply complacency in the mainstream view

While this January has obviously been the worst on record for stockmarkets, a snap-back in response to ECB president Mario Draghi's hinting at more European QE from March shows plenty are still willing to buy the idea that dividend yields and central banks are a back-stop for equity values.

Indeed, a group of fund managers, early-morning on Radio Four, dismissed the jitters merely as "short-term risk-aversion". Mainstream fund managers' perennial advice is to ride out volatility. However, the last thing they want is redemptions destabilising funds, so "they would say that, wouldn't they".

Those private investors who survive long-term tend to respect a sense for stop-loss; they appreciate that there are times for even long-term equity bulls to pull in horns. Fund managers are in a quite different situation, needing to deploy money continually coming in - and if they miss an upswing then their jobs are more at risk than if they stay invested in a downturn, when it's still possible to "outperform the market".

By contrast, global hedge funds' shorting of FTSE 100 stocks has risen to the highest level in over five years, showing that those attuned to absolute return and downside risk are positioned to exploit it. More money is being allocated to short bets, largely after the US has ended QE, helping explain recent equity falls.

This is not necessarily something to fear, as at some point the stock needs buying back. A list of "the most shorted stocks" is often prime for contrarian investors/traders, as closing out a crowded trade usually means a sharp recovery.

But the long-term survivors among hedge funds are no fools either. Significantly, Lansdowne Partners wrote to its investors in October saying it hadn't put any new bets on rising stocks of any scale during 2015, while it had spotted at least 10 new attractive bets on falling stocks.

Britain set to maintain 2.2% growth

Latest numbers from the Office for National Statistics affirm 2015 ending on "a soft note", with fourth-quarter GDP growing by 0.5% as compared to a rise of 0.4% the previous quarter.

With 2.2% overall growth in 2015, this still puts Britain among the fastest-growing advanced economies and the International Monetary Fund considers 2.2% will persist in 2016 and 2017.

Consumer demand has remained broadly solid, helped by falling prices and record employment, although, as I've pointed out with recruiters, they tend to be a late-cycle feature; i.e. expect to see them beating expectations even when some areas of the economy are turning down.

The IMF forecasts are best taken with a large dollop of salt; even one of its own economists has concluded that "the record of failure to predict recessions is virtually unblemished".

As yet, 7.4% of listed companies warning is not cause for alarm, but the risk is a steady creep to undermine dividend yields. Prime time, therefore, to assess dividend security and dividend cover on stocks you own, not only in terms of relying on income, but also whether yields are really a prop.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.