Following the Smarter Money Lower

If you caught the market action Friday, you already know that the fear among global traders that had been churning under the market's surface has now bubbled to the top. Sure, we've endured some wild swings in the market lately, but Friday was different, because the currency and commodity traders started to get nervous along with their always-jittery, often-downright-craven cousins, the Wall Street stock traders. During the past few months I have claimed that, since the euro/dollar (how many U.S. dollars it costs to buy one Euro) has hovered consistently around $1.45, concerns of a Greek default (and subsequently a Spanish and Italian meltdown in the bond markets) were merely traders looking for an excuse to sell U.S. equities. Also, I have maintained that the fears of a U.S. double-dip recession were overdone because oil prices have remained stubbornly high. These two more accurate predictors of future unpleasantness than stocks, the currency market and oil futures, began to turn lower Friday, which means that the smarter money has begun to show concerns that a default in Greece will, within the next year, cause a contagion similar to the Lehman plague from a few years back, from which we have yet to recover.

The euro/dollar plummeted Thursday and Friday from $1.45 to $1.36, which by currency volatility standards, is an enormous move in two days. Less spectacularly, light sweet crude oil, now called West Texas Intermediate (WTI) to confuse everyone, traded between $89.50 and $85.64, which although still stubbornly high if we are indeed headed into another recession, nevertheless is moving in the right direction if we are about to see a European contagion induced double dip, which is, of course, the wrong direction for the handful of us who are long stocks. Here's what to watch. If the euro/dollar dips below $1.30 and stays there for an extended period of time and if WTI falls to a 70-handle and closes there, that means the smarter money believes the whole European contagion issue is more than just a media event on CNBC. That's when stocks will see even deeper declines (and fast) than we've been enduring this summer. If you are assembling the (almost) permanent portfolio as I am, you'll want to take advantage of the market turmoil by initiating or adding to existing positions of strong, large, cash-hording, dividend-paying U.S. multinational stocks, such as General Electric (GE), Pfizer (PFE), and RPM International (RPM), all of which I have recommended previously.

Last week I recommended RPM as a stock that has raised its dividend 37 years consecutively and that has an impressive list of global and industrial brands, like DAP and Rust-oleum. In the interest of full disclosure, I must tell you that Friday, in the midst of the market mayhem, I traded that stock successfully by buying a whole bunch of shares at $17.75 early in the afternoon and selling my shares at 3:57pm for about $18.05. This sort of trading, which is not really day trading, because I only traded with a relatively small percentage of my portfolio (and not all of it), is only for those of you with cash you are willing to have trapped in a stock for a long time, in case the trade does not work out in your favor. For the short-term trade I find a stock that I have wanted to own for a while with a strong dividend, a stock like RPM, that I would be willing to add to my (almost) permanent portfolio if the stock falls precipitously, and I buy many, many shares during the day at a time of extreme panic in the market (in Friday's case resulting from rumors that Greece was going to announce a default on its debt this weekend, which still hasn't happened yet at the time of this writing). I will sell the stock, all of it, that I'm trading once I have reached a predetermined profit on the trade (minus commissions and fees, which should be under $10 per trade if you're using the right broker). This sort of trading is not for the meek, especially in these uncertain times. Some call this gambling; I call it trading.

You are probably better off to keep adding to solid positions that you are willing to keep (almost) forever. This week we may see a European meltdown, and I might use the volatility to trade RPM again because my guess is that Germany does not want to cast out Greece, its prodigal son, yet, from the Euro zone; Germany will probably wait until later this month or October, when most stock market crashes seem to occur. If that happens, I'll roll up my sleeves and buy, buy, buy.

Reward and its Ugly Stepsister Risk

Remembering that I promised never to talk about politics in my articles, I will not mention the disturbing development this past week that the U.S. Government has now decided to sue the large U.S. money-center banks with two separate agencies and two separate lawsuits. Are these the same politicians who are wondering why U.S. banks are not lending and why U.S. consumers are too petrified to borrow, even those with good, stable employment? Economics has never been a strong subject for American politicians, maybe because it involves so much math, but surely someone, somewhere in the U.S. Government regulatory agencies can follow this (I'll even type slowly): If banks were reluctant to lend to consumers and business two weeks ago, they will be even more loath to lend now that, after regulators have forced them to increase their capital reserves to ridiculously high levels during the past three years, they will have to replace that capital after what can only be a sham of a trial, or more likely an expensive shotgun settlement. Oh, the Europeans have always been better at economics (and math) than we are.

Because of policy mistakes in the U.S., we now are facing the increased probability of a recession. What should we do? If you have a steady stream of investable savings, you should, as the stock market makes new lows, keep adding to positions of large multinational companies with good, stable dividends, like General Electric (GE) and Pfizer (PFE). Therefore, when the U.S. finally comes out of its slow-to-no-growth slump, the shares in your (nearly) permanent portfolio will swell with a healthy, wealthy glow. This is when your risk-tolerance is tested as an investor, and even if you never buy bonds, risk in finance is defined in terms of U.S. Government bonds.

A bond price and its yield are inversely related, that is, when the price of the bond decreases, it's yield, or its payout as a percentage as the bond price, increases. So, when bonds get cheap in value, their yields rise, and that's one way to determine how risky a bond is as an investment. You simply look at its yield compared to Treasuries, bonds issued by the U.S. government, and if the bond is trading at 5 percentage points above the Treasury yield, then it has a credit spread, sometimes called a risk premium, of 5%. A bond trading with a risk premium of 5% would be a very risky bond in the eyes of the market. In other words, the bond market, with such a high risk premium, is betting that the bond may not be able to pay its promised interest to investors and, therefore, might default.  

We also can apply the concept of risk premium to stocks and their dividends, more or less. Let's say that a stock, based on its current price, boasts a 7% annual dividend yield. The market is betting that in the future the company will not be able to pay the dividend that it currently offers; otherwise, investors would dive into the stock, driving its share price up and thereby pushing its dividend yield lower. What is a good dividend yield for a stock? That depends largely on market conditions and the company's industry. Currently, dividends are relatively high owing to a general disdain for stocks and the lack of ownership of stocks among investors like us, referred to in the financial media in the aggregate as the retail investor. For example, you can get a health care company's shares, like Pfizer (PFE), which pays a 4% or 5% annual dividend yield or a utility such as PP&L (PPL). Most dividends in these industries are safe because we are coming out of a once-in-a-generation-financial collapse, when all companies who would have had to reduce their payouts would most likely already have done so. Dividends will rise in the coming years with stabilization in the global economy.

RPM's chart is ugly, but at these levels the stock is interesting.

Years ago I traded RPM International (RPM), and lately I have been interested in building a new position in the company's stock. Friday in the general sell off, the stock closed at $18.64 and currently pays a dividend of $0.21 or a 4.5% annual yield, which, at roughly 2.5% over Treasuries, indicates that either the market sees significant downside ahead for the stock price, namely another recession, or that traders have indiscriminately sold off RPM shares owing to their general disdain for stocks. I think that the latter is more likely the case, and that the current sell off in RPM shares presents a good opportunity to begin building a position in the company. RPM International is basically an industrial chemical company that sells all sorts of specialized  sealants and coatings. The company's most recognizable brand is Rust-oleum, but you probably have other products of theirs in your basement, workshop, or garage, like Dap, which is a popular brand of caulks and sealants. What will happen to RPM if we have a recession next year? RPM's stock price will go down, but chances are the company will do everything in its financial power to keep paying and increasing its dividend. For 37 consecutive years, RPM has raised its dividend, and that means it even raised its dividend during the Great Recession we just went through (and are still feeling). That sort of streak of dividend raises, of course, continues until it doesn't anymore, but RPM, with a streak that impressive, will likely continue it through the next recession, whether it occurs within the next year or five years hence.