Consolidated Edison, Inc. (NYSE:ED) stock has become a trading vehicle for whether the Fed is going to raise rates. In a rising rate environment utility stocks, which are bought because of their dividend yields, become less attractive. I talked about the reason why ConEd’s stock has gone up in my last article on the company. Investors are increasing their risk tolerance because central bankers are buying bonds. The Fed is buying government bonds, the ECB is going as far as buying corporate bonds, and the JCB is buying everything it can get its hands on. This artificial suppression of yields have caused $14 trillion in government bonds to reach negative interest rates, the lowest interest rates in human history.
These low yields cause pension funds to move into stocks. The best replacement for a bond is a utility stock as its dividend is very consistent. When yields rise, this situation will cause Con Ed stock to fall. This makes me bearish on the stock in the long run, but I am still bullish on the stock in the short run. This has been wrong since the last post, but I’m sticking with it. Utility stocks typically do well during economic weakness. If investors are looking at a rate hike are extrapolating that the economy is in great shape and are using that as an excuse to sell ConEd stock, then they wrong. I will prove this in congruence with my point on why the Fed’s rate increase cycle is ending.
Based on my analysis the credit cycle is ending. Whether or not the Fed raises rates a quarter point is meaningless in comparison to the larger issue of where we are in the credit cycle. If you knew the economy was headed for a recession and if the Fed raises rates in September it is likely to be its last increase for the cycle, you would not sell ConEd on this small news event. Contextualizing this rate increase is possible, by looking at the last increase. It was a small quarter point hike that did nothing as the Fed’s balance sheet is still at $4.5 trillion and rates are still lower than ever before.
Looking at ConEd’s stock, it fell about 10.5% in anticipation of December rate cut, but then rallied as the market grew uncertain since it could barely handle that small increase. ConEd stock has now fallen 8.5% in anticipation of the possible rate hike in September. If it doesn’t occur, the stock will rally. If it does occur, it won’t sell off too much because it is already priced in. The market will once again realize that in a growing economy the Fed has raised rates one quarter point per 10 months. If the economy indefinitely grew, it would take years for rates to normalize. In the likely scenario of a recession in the meantime, rates will go back to zero. In Yellen’s Jackson Hole speech, she said $2 trillion in QE was in the Fed’s toolbox for the next recession. This is bullish news for ConEd stock. QE has proven to boost all stocks and ConEd is a great way to play this rise along with the need for yield.
Getting back to my point of a recession causing the Fed to cut rates and go back to QE, the key point in my projection for a recession is the credit cycle. One of the indicators used to measure the cycle is below. The recovery rate is the rate investors can sell bonds after default. The recovery rate is at its lowest since it has been measured. While this is because of energy and mining, the 31.25 recovery rate is below 46.01 which is the average rate. This signals we are headed for a recession.
The second chart I have shows the default rate of high yield bonds. These bonds are at the margin, so their default rate shows the strength of the economy. The current default rate is 5.5% which is above the 3.4% long term average. This shows the cycle is turning. While no one can predict this with absolute certainty, the cycle being 6.5 years old (1 year longer than the average) leads me to believe the cycle is over and a recession is coming.
The chart below shows the payout ratio for the S&P 500 being at a record. This is a bigger deal than it seems. The payout ratio in 2009 was high because we just exited a recession which caused earnings to plummet. In the current case, there has yet to be a major swoon in earnings, so when that happens we could be looking at even high payouts. This means dividend cuts are coming. I think the payout ratio is so high because investors are valuing dividend stocks more than usual because of low bond yields. This may encourage more dividend hikes and less cuts.
The chart proves two points. The first point is that we are likely at the end of the business cycle. Another part of the reason why payouts are reaching records is because this is the 4 th longest economic recovery. It is long in the tooth. In fact earnings are about to fall for their 6 th straight quarter, showing the weakness in the economy and providing another reason why payout ratios are so high.
The second point this chart shows is that dividends are about to be cut, so the companies least likely to cut their dividend are the most valuable. ConEd has a 42 year streak of raising dividends. Given that it was able to survive the 2008 recession without cutting it, I don’t see why the streak will be broken by the next recession. The company has a policy of keeping the payout ratio between 60% and 70%. With the current payout ratio at 64%, the dividend looks to continue to be safe. This makes the stock valuable as dividends will likely be cut by other companies as the cycle rolls over and payout ratios reach new record highs.
You may consider my point inconsistent because I said the ConEd 63% payout is sound, but the 38% S&P 500 payout isn’t. The reason why this makes sense is because ConEd has a more consistent earnings stream than most companies. Secondly, the 38% payout is just an average, so the ones above that are the ones which will be more likely to cut their dividends.
ConEd is clearly trading on macro news as the stock has sold off prior to anticipated rate hikes. Given that it’s down over 8% in anticipation of the September hike, I think it’s fine to buy the stock here as it is already priced in. The reason I was wrong about my previous recommendation is because I underestimated the chances of a rate hike. I still don’t think it will happen. Either way the focus on this one hike misses the forest for the trees as the Fed is very close to the end of its hiking cycle given the credit cycle is signaling a recession is coming. If a recession is coming and dividends start to get cut, ConEd is a great stock to hide out in.