Tuesday, February 26, 2008

The next bubble in the making.

Over the past 10 years the US economy has experienced the bursting of two major bubbles – the dot com bubble and the real-estate bubble. The Federal Reserve has been blamed for both failures – the first one happened supposedly because the US central bank hesitated to increase its interest rates too much until tech stocks started jumping like kangaroos in the Australian deserts in late 1999. The second bubble was formed just as the dot com bubble imploded and the FED tried stimulating the economy with lowering interest rates to multi-decade lows. Rates on fixed income instruments had fallen to multi-decade lows, and stocks were in a major bear market. Investors had nowhere to go for income. This situation stimulated speculation in the housing market and helped the US economy regain its power and achieve six years of prosperity.

Currently the US and Foreign stock and property markets are weak, ever since the subprime problems started making huge headlines in July 2007. Interest rates are declining again, which leads very few options for investors to invest and grow their savings right now. Somewhere down the road real-estate would pick up again, but it is still too early for that to happen in my opinion. One of the reasons for today’s real-estate bubble is that properties were sold to people who cannot afford them at all. If you are making $20,000 per year and you purchased a property for $500,000, which you were able to afford only with an ARM, with the intent of flipping it out for a huge profit, even if you refinanced your loan to a 0% interest per year, you would still be unable to keep up with the monthly payments. Most of those investors are holding such properties which they cannot afford, but which would lead to huge losses if they sold them right now. Those investors are trying to rent their properties in order to decrease their losses. This creates a very competitive market for landlords right now. Pundits are claiming that now is the time to buy into real estate. I believe that the next one or two years will also be considered “the time” to buy real estate. When no one believes in the real estate market, that’s when it will bottom out and start going up.

One of the few alternatives for investments is stocks that pay a relatively stable dividend, and which have maintained or increased their dividends over the years. There are several dividend based ETF’s out there some of which launched recently. This shows to me that the investment community is anticipating a demand for stable income producing securities in this unstable time. There are several major stock lists out there which contain dividend achievers, dividend aristocrats and high-yielding aristocrats and achievers. With very few reliable sources of dependable income from stocks, investors have few other choices but to invest in the dividend stocks of our times. I think that the dividend aristocrats would be the next bubble that will be formed from the current low interest rates. Investors, burned from the rest of the market, would flock into one-decision large cap stocks with good liquidity, which could be bought and held forever regardless of price. Something similar happened in the late 1960’s until the 1974 bear market with the so-called “Nifty Fifty” stocks.

I am already seeing big increase in interest in dividend paying stocks especially the above mentioned lists. If a bubble in dividend aristocrats/achievers does occur, that would enable me to reach my goals of $200,000 in net worth earlier than expected. If it doesn’t happen, then I would probably expect normal average rates of return of around 10%-11% annually. Very Boring.


  1. If dividend stocks are the next bubble, what factors would cause it to burst, especially since these are "hold-forever" investments?

  2. Jdiggity,

    This is a very hypothetical article so my answers would be hypothethical as well. This relates to the Dividend Aristocrats and Dividend Achievers, not to all dividend stocks.
    Either interest rates will rise substantially and thus investors who have bought the abovementioned stocks on margin would want to sell at the same time or a major change ( tax change) might make it prohibitely expensive to pay dividends or maybe a recession could make most of the dividend growers to cut or stop increasing temporarily their payments.

  3. One factor which could mitigate a dividend bubble is that any positive cash flow corporation has the option to become a dividend yielding stock. So if the demand for dividend stock became extraordinarily high, then new supply would rush in. However, low yields on bonds make it cheaper for a company to raise capital through borrowing than through enticing equity investors with big dividends.

    I believe that bonds are at a greater risk of a bubble. I suspect that too much capital has migrated from equities to bonds. This has at least two consequences: bonds are priced too high (bubble potential) and too little equity puts companies at greater risk of default (bubble induced added risk). The burst of this bubble will happen when there is a surge of defaults (bubble trigger).

    This is exactly what happened with real estate. Too much capital entered the housing market. Prices went up (bubble potential). Under conditions of rapid price appreciation, banks became increasingly willing to lend to marginal home buyers at very high loan-to-value ratio. These latecomers had little or even negative equity at origination before the bubble burst. It made sense to do so because a year or more at 20% appreciation meant that a comfortable 80% LTV would quickly follow. Mortgage defaults are exceedingly rare when there is a modest amount of positive equity because distressed borrows have the option to sell the property with dignity intact and a little bit of cash. But with thin equity, there is no second way out and the risk of default blows up. So thin equity induced added default risk which were not being properly worked into the price. Now the bubble is fully inflated and set at risk. A small hiccup in employment triggered a uptick defaults. Not enough buyers are to be found, and prices collapse 30 to 50% within the span of twelve months. Mounting negative equity triggers a flood of defaults. Still even two years latter more than 1 out of 10 mortgages are in default.

    Bond investors need to be very wary of creeping default risk. To protect bondholders capital needs to flow back into equities. Dividend investors stand between the risks of price volatility and bond default risk. They are an important buffer between these risks. If a dividend yielding company becomes financially distressed, it has the option of cutting dividends, giving it a way to avoid default while it works out its cash flow problems. The same company without dividend investors will have little choice but to default. Now the options for recovery become quite limited, as the company gets reorganized in a way that is not favorable to stockholders. Hence, both bondholders and stockholders are placed at greater risk for lack of dividend investors who help absorb economic shocks.


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