When stock market bubbles burst, investors get hurt. That’s a given… But not all bubbles are created equal, and some are more brutal than others.
The dot-com crash in 2000 wiped out a tremendous amount of wealth. But one could argue that many investors deserved what they got. Paying nosebleed prices for companies with no earnings was recklessly speculative, and it made perfect sense for many of these stocks to crash spectacularly.
The financial crisis was a bit more complicated. Sure, there were home buyers who should have known better than to buy houses they couldn’t afford. And financial institutions trading mortgages had to understand the risks they were taking.
The next market crash will hurt conservative investors who can least afford to sustain losses.
But most individual investors who owned bank stocks couldn’t be expected to understand the risks these banks were taking, and many innocent investors saw their brokerage accounts brutalized.
Today, markets are at a dangerous spot where a new market bubble is poised to burst. This time, the “orphan and widow” investors who can least afford to take risks will be the ones shouldering the bulk of the losses.
In part one of this series, we discussed the “reach for yield” concept in which conservative investors have moved money out of bonds and deposit accounts and into dividend-paying stocks.
This move was necessary because the Fed’s zero interest rate policy made it impossible for these investors to generate enough money from deposit accounts or low-yielding treasury bonds. As we come to the end of the zero interest rate era, this trend will reverse.
Proctor & Gamble: A Dangerous, Crowded Theater
Shares of Proctor & Gamble Co (NYSE:PG) have benefited tremendously from the Fed’s zero interest rate policy. The stock is the single largest holding in the S&P Consumer Staples Index (XLP), and the share price has doubled since the Fed dropped rates to zero.
The advance in share price has been a great boon to conservative investors who not only collected an attractive dividend from the stock, but also saw the value of their underlying investment appreciate.
These investors will be wise to take profits at this point as the trend is in jeopardy of reversing.
Due to a flood of capital chasing dividend payments, PG’s forward valuation (the price investors pay for every dollar of expected earnings) has moved steadily higher.
When the Fed first announced its zero interest rate policy, investors were paying roughly $11 for every dollar that Proctor & Gamble was expected to earn. Today, investors are paying nearly $19 for every dollar of earnings – one of the highest readings on record!
Proctor & Gamble currently pays a quarterly dividend of 66.3 cents per share. This nets out to $2.65 per share each year, or a 3.4% dividend yield. This yield is more than 70% above the 1.95% yield on the S&P 500. It’s also well above the 2.4% paid by 10-year treasury bonds.
With its strong dividend and a history of stable profits, Proctor & Gamble is clearly attractive to conservative investors who need to create income from their portfolios. This is exactly why the stock has traded steadily higher (and why the stock’s forward valuation has increased) during the zero interest rate era.
Unfortunately, this trend can’t continue much longer…
PG’s Growth Doesn’t Support its Valuation
Why would an investor pay nearly 19 times earnings for Proctor & Gamble today, versus only 11 times earnings for the same company in 2009?
In a normally functioning market, investors would pay more for a company because they expect significant growth in the future. But that’s not what is happening with Proctor & Gamble.
PG’s business is steady, but growth is essentially non-existent. In fact, recent revenue trends show that the company’s business is plateauing – if not slightly declining.
Based on the company’s revenue growth, it is clear that the premium valuation for PG is not due to the company’s growth. Instead, investors are plowing capital into this stable company in an effort to capture an attractive dividend. This dividend is attractive to conservative investors primarily because they have few other options to generate the same level of “safe” income.
A Sea Change For Interest Rates
As mentioned, PG’s dividend yield is very attractive compared to other “safe” income investments. The current yield on the ten-year treasury is not far from record lows as seen in the chart below.
But what happens when interest rates (and corresponding yields on treasury bonds) move higher?
Treasury bonds are some of the safest opportunities for income investors because the principle is guaranteed by the full faith and credit of the United States.
Income investors may be shunning treasury bonds today because of their low yields, but when treasuries offer the same yield as blue chip dividend stocks like PG, it will make more sense for these conservative investors to sell shares of stock that could lose value, and buy treasuries which are guaranteed.
A strengthening employment market will give the Fed the support it needs to boost rates this year. Now that the U.S. economy is largely back on track, the Fed will be under pressure to move interest rates back to more “normal’ levels
As this transition takes place, the forward valuation level for PG should also move back to a more “normal” level.
What is a normal level? Well, that depends on how high interest rates move, along with profit expectations for PG.
Today, analysts expect PG to earn 4.18 per share over the next year (for the fiscal year ending June 30, 2016). If PG’s valuation moves back towards a level of 15 (a rough average from the last several years), the stock price would drop to $62.70. This is more than a 20% decline from the current price.
If investors are only willing to pay 11 times forward earnings as they were in 2009, shares of PG could fall as far as $46 per share. This is more than a 40% decline from the current level.
And these two scenarios still assume that analyst expectations for PG’s forward earnings are correct. If the company’s plateauing causes earnings expectations to drop, shares could decline even further.
While PG has a longstanding history of solid profits, the current stock price is reflecting a perfect environment of low interest rates and a reach for yield.
As that environment shifts, conservative investors will likely stampede for the exits, causing a sharp drop in the stock. We recommend avoiding this popular consumer staples stock at all costs.