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Value at a Premium

By Ari Charney on July 14, 2016

The phrase “lower for longer” has broad application these days. It first entered the parlance in the middle stages of the energy downturn, when it summarized the conventional wisdom about where crude oil prices were headed.

Lately, it’s been pulling double duty in the realm of interest rates. Most of the world’s central banks have opened their monetary spigots, while even the U.S. Federal Reserve, which is nominally in rate-hiking mode, has been repeatedly forced to defer its next rate increase.

Meanwhile, the Fed has been steadily lowering its long-run forecast for its benchmark federal funds rate. Its most recent projection is just 3.0%. Based on futures data aggregated by Bloomberg, traders don’t expect another rate hike until the middle of next year.

Similarly, the Bank of Canada, which is holding its own benchmark rate at 0.50%, just a quarter-point above its all-time low, isn’t expected to make a move anytime soon.

Clearly, rates are going to be lower for longer, too.

And with the Bank of Canada’s (BoC) latest Monetary Policy Report, it’s becoming clearer that economic growth can also be characterized as lower for longer. The central bank revised its forecasts for economic growth sharply lower this year.

However, it does expect a moderate reacceleration in the final quarter of the year. And the bank maintained the status quo on its projection for 2017, at 2.1%, though it pared its forecast for 2018 by a tenth of a point, to 2.1%. That’s a decent improvement from this year, but still well below the 2.5% level the BoC has previously identified as the minimum threshold to remove excess slack from the economy.

Thus goes the New Mediocre.

Of course, the BoC had good reasons for lowering its estimates, including the Alberta wildfires, which sidelined significant crude oil production and caused enough damage to make them the costliest natural disaster in Canadian history.

Hurry Up and Wait

Nevertheless, at this point, it’s starting to feel like the world’s central banks are stuck.

The Fed is contending with a labor market that, aside from the most recent employment report, has been weakening, while trying to grapple with a global economy that seems to be reeling from one crisis to the next.

Likewise, the BoC is straddling a fine line between being supportive of Canada’s economy, while trying to let the air out of the country’s housing bubble.

Collectively, global central banks’ decision to remain extraordinarily accommodative is causing equally extraordinary dislocations in debt and equity markets.

For instance, one-third of global government bonds from developed-world countries (more than $7 trillion worth) sport negative yields. That’s forcing bond refugees into dividend stocks, driving yields down and prices up, leading to valuations for some utilities that are more akin to those one might normally expect of growth stocks.

Now we’re starting to see investors defending such premium valuations on the basis of rates being lower for longer. That’s got our contrarian sense tingling.

As income investors, we’re having a great time. Indeed, we don’t normally expect our favorite dividend stocks to produce eye-popping returns.

But we’ve been around long enough to know that arguments about how it’s different this time inevitably prove wrong.

We don’t know what will cause dividend stocks to revert to more normal valuations. It could be a stock market that goes back into risk-on mode. We’re getting a small taste of that this week.

Or it could be a rogue Fed policymaker giving a hawkish pronouncement on the future direction of interest rates, which then gets echoed by one of their colleagues.

Another Way to Stay Disciplined

When it comes to dividend stocks, it’s hard to stay disciplined since keeping some of your portfolio idling in cash means that you’re missing out on crucial income.

And the moment you decide to forego discipline will be the very moment dividend stocks finally correct. After all, the market exists to make fools of us all.

But there is another way for value-conscious income investors to wring money from their holdings, while waiting for sanity to prevail: options.

Over the past month, Canadian Edge has begun employing low-risk options strategies, including covered calls and protective puts, to generate additional income from our favorite stocks or provide insurance against an eventual correction.

This bolt-on strategy has already produced some impressive short-term returns, ranging from 31% to 38%. Not a bad way to bide your time until more bargains emerge.


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