Grab Your Crampons—Stocks Have Entered the “Death Zone.” Plus, Dividends At a Discount.

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The one thing I'm unequivocally clear about is that the real return will be lower. That's true whether we're talking about stocks or bonds, no matter what your investment is, because inflation's higher your real returns are going to be lower.

Hello and welcome to the Barron's Streetwise Podcast. I'm Jack Howe, and the voice you just heard, that's Mike Wilson. He's the Chief Investment Officer at Morgan Stanley, and he says that U.S. stocks have entered the death zone. I feel like that's probably negative, but we'll see. We'll also hear from Alastair Pinder. He's a U.S. stock strategist at UBS, and he says It's a particularly good time to buy dividend stocks. We'll hear why. Filling in for Jackson as our audio producer is Meta. Hi, Meta.

Hi, Jack.

I want to read to you a headline. I follow some of these science accounts on Twitter, and sometimes they just drop something without a lot of context, and I don't know how concerned to be. On a scale from, let's say, 1 to just Abject pants-wetting terror. How should I feel about the following? It says, breaking: runaway black hole the size of 20 million suns has been spotted traveling through space. I mean, right off the top, like, the word runaway— I thought, first of all, in space that all motion was like relative. So how do you know who's running away from, from whom? Although maybe they just mean runaway as in it's growing out of control, which is even more of a problem. And then spotted traveling through space. Like, I think space, I'm pretty sure, is big. So where in space? Like, how far roughly? And then 20 million suns. I'm not an astro— I'm not an astronomer.

Oh, come on. You're not?

I'm not a guy who always gets the difference between astrologer and astronomer right. I'm not a star scientist, but, um, I feel like 20 million suns is a lot. I feel like that's more suns than you usually hear about in one place. So what should we— do we even go on with the podcast? Because I'll go right now down to the store and I'll buy a box of Cinnamon Toast Crunch and a half gallon of whole milk, and I'll come back to the house and I'll say goodbye to my loved ones. That's my rough plan, and pretty much in that order too. Or we can go on with a podcast if you think it might be okay.

I think we should do more research before we panic.

You know what, that makes, makes a lot of sense. Let's get to Mike Wilson and a jarring piece of analysis that he published this past week. It's on the U.S. stock market, and the title of it was Into Thin Air. That's the title of a book from, I think, a little over 25 years ago on an ill-fated expedition on Mount Everest. Meta, my mountaineering sound effects, please. He uses a phrase in this report, the death zone. That refers to a particular altitude on Mount Everest where apparently if you go into the death zone, you know, good, good things don't happen in the death zone. I feel like that'd be a deal breaker for me if I'm taking a vacation and people are saying, hey, let's— we're putting together a mountain expedition, I say, "All right, that sounds pretty adventurous. Where are we going?" They say, "Well, we just have to pass through the death zone." I'd say, "Hang on, let me stop you there. I try to stay out of the death zone. If you've got a beach zone, if you've got a beer tent, let's talk about that, but I'll probably skip it." My advice on surviving the death zone is stay out of anything that has a death zone. I want to just mention two things you'll hear Mike say in case you're not familiar with the terms. One of them is equity risk premium. And I'm not going to get too far into the weeds on that, but just think of that as being a way to say, since yields on very safe bonds are higher now than they were, stocks have more competition, right? They might not look quite as attractive in comparison. And the other thing you're going to hear is the difference between bottom-up and top-down estimates for earnings for the overall stock market. And that just means When we say bottom-up, that's you take the earnings estimates for individual companies from all those individual analysts and you combine them to make one estimate for the overall stock market. Versus top-down is where a strategist or an economist might say, here's what we think based on broad factors right now that earnings are going to look like. So that's it. Let's play the conversation. I got to tell you, death zone sounds pretty bearish.

What are—

that was in the, that was in Text, Jack. The title was Into Thin Air. Come on.

Yeah, I know. I remember it. So yeah. Tell me what has you concerned about the level of US stocks.

Yeah. I mean, look, obviously titles aside and metaphor aside, it is a very precarious position right now for US equities when looking strictly at valuation.

Okay.

Given the setup that we see fundamentally, which is that we are pretty vocal about the earnings risk. Well, first of all, 155 basis points on your equity risk premium is fairly unprecedented in the last 15 years. Now, we've had negative equity risk premiums in the past and people are trying to make this kind of, I would call it, an argument that's based on a period that we're not in anymore. So for example, in the '90s, we had negative equity risk premiums, and even in the early 2000s, But there was a very specific reason. It's because we were in a disinflationary world where rates were still high and they were coming down. The market was looking ahead saying, "Well, in 5 years, rates will be lower, so I can pay myself today with a lower risk premium." That's a valid argument. Today, I think it's very challenging to feel comfortable saying that in 5 years, 10-year yields are going to be significantly lower. I mean, in fact, I would argue they might be higher given the regime shift that I think Most people who are in the weeds on this would agree that we've turned a corner on inflation. It doesn't mean we're going to have 10% inflation every year, but what it means is unlikely we're going back to negative real rates and financial repression and all the things that we did for the last 20 or 30 years. There's other features too, like globalization going the other way and capital labor shift and productivity boom that we had in the '90s, which we don't have today. So a lot of things to make that assumption, I think, is is a bit naive. So that's the main reason we think markets are poorly priced right now, in addition to the fact that our earnings model is projecting the earnings this year are going to be at least 10%, if not 15% below the current consensus estimate.

[Speaker:BILL TAI] What leads you to think— we just came through an earnings season. What are the signs you see that make you think that we're going to come in below where the rest of the street sees earnings?

DAVID SHERMAN] So yeah, I mean, our model is all top-down and it's based on existing data that's already been recorded. It's all macro top-down data, things like consumer confidence or housing starts, dollar, and it has a terrific track record. I mean, we've been using it for almost 25, 30 years and there are periods of time when it does get out of whack with consensus, meaning if you think about it this way, right? And bottoms-up analysts, tend to follow along with company guidance pretty closely. That's neither here nor there. It's just the way it is. And so you'll get guidance and basically the numbers will kind of track. We have very little dispersion in kind of individual company forecasts because of that. And sort of the independence on forecasting is not as good as it maybe was 25, 30 years ago. Okay. Fair disclosure is a big part of that. Because of that, at major turning points, both on the up and the down, what ends up happening is the investment community misses that turn, the magnitude of it, because they're not actually doing forward forecasting. They're just kind of extrapolating off the current quarter and saying this is what's going to happen. So in other words, you ask the question, what about the last quarter tells me that that's going to happen? Nothing, other than the fact that it's exactly in line with what our model projected 12 months ago. So in other words, the actual results are right in line with what our model was saying a year ago. Now, a year ago, I was making the same call that earnings would be much worse than what the consensus was forecasting. And of course, we kind of got dismissed then too. And that's exactly what happened. Say, for example, a year ago, the forecast for 2022 earnings was around $235 and it turned out it's going to be like $220, $222. So that's a pretty good miss. More than your normal adjustment. Next year, or this year rather, we're now forecasting it's like 195, and the current consensus is still 223. Bigger difference.

That's a big difference. So what should I do then? First of all, where do you think this will take US stocks, and what should I do?

Well, our recommendation has been and continues to be that you need to be in areas where that earnings risk is lower. So let's talk about where the risk is higher. So the risk in earnings is in the areas where industries over-earned the most during COVID And I think two easy ones there would be technology and consumer goods. I could also throw financials into that and some of the industrial space maybe, and some of the consumer services now are starting to over-earn as people get back to that activity and they got good pricing power. So we're looking for areas where the earnings line is way above trend, and those would be the 3 or 4 sectors. And what you really want to focus in on are companies or sectors that are extremely good at operational efficiency, meaning getting their costs in line and not getting too far out of control. Those tend to be more defensive sectors like healthcare, things like consumer staples that have the ability to control costs and package differently or price differently. Based on the size of the package, things like that. And then of course, there's some companies within those other segments that are good at managing their businesses. You can imagine a good operator in the retail world versus a bad operator, for example. Okay? So that's what we've been doing. That's what our portfolios we constructed. So last year we have a focus list. It's just 10 stocks. And that list was actually up last year about 5%. So there were things to do. And that strategy continues today, even though we've had this rally so far this year in more speculative parts of the market, We have not participated in that. We're still hunkered down into this boring portfolio because we think that earnings risk is still there and that our strategy will prove again to be the right strategy. So that's what we think you should be doing until we think it's priced. And then once we feel like it's priced, we're going to see some big shifts from us in what we're recommending to do. And it's going to be something much more aggressive than what we're doing right now.

[Speaker:TREY_LOCKERBIE] How much downside do you see from here for US stocks?

So it depends once again on the stock, but we'll just use S&P terms. We're in print saying we think it could be somewhere between 3,000 and 3,300. We still think that's very plausible. I think at a minimum though, it's probably just back to the lows of October, which is 3,500. So that's where we would probably start to add risk. In October, we made a call to get bullish at 3,500, kind of right at the lows because of price. So we'll be disciplined around that, meaning we're not going to try and catch the exact low, but the risk-reward at 4,100, 4,200, which is where we were recently, was, we think, pretty poor, which is why we put that note out a little bit more, the funky metaphor, just to make a point.

Does it matter? There's been this discussion around, first people were thinking about, is it a hard landing? Is it a soft landing? Now is it no landing? Does the shape of the economic slowdown matter that much, or is this mostly just related to stocks look expensive, and bonds are a better deal than they used to be.

David Sherman: Yeah. And I would caveat that last part of that statement is that T-bills look more interesting. Okay? So I'm not sure you need to be taking a lot of duration risk right now, given that the Fed is not finished. I mean, quite frankly, we thought the Fed would be finishing up in February, and of course, the data's been better. So in some ways, ironically, right, the persistence of the jobs market is a good thing for people, and the jobs market and maybe the economy, not so good for the markets because it keeps the Fed continuing to raise rates. That's still a major headwind for equities is the Fed's still in the game. They're not being accommodative anytime soon. And that probably has been pushed out through the rest of this year. So we kind of talked about this with our economists, like they're in kind of the muddle-through camp. Like their base case is no recession this year, no labor cycle, but from an equity market standpoint, that's actually maybe worse than a recession because if you get a recession, then you clear the decks and you can still have a new cycle that people get excited about. And by the end of this year, you can actually be at higher stock prices. So it's kind of a weird setup.

[Speaker:BRAD_STONE] For the person out there who's like, they're not a tactical investor, so maybe this will be lost on them or they won't respond to it, but they are going to be invested for the long term. So they're going to be in it for the next 10 years. Maybe they see this downturn over the next year that you're forecasting or warning about. But what do you— when they look back after 10 years, what do you think they're going to see in terms of how their returns have been? As good as they've usually been? Worse than average? What do you think?

Well, I would say the one thing I'm unequivocally clear about is that the real return will be lower. That's true whether we're talking about stocks or bonds. No matter what your investment is, because inflation's higher, your real returns are going to be lower. I would also say that stocks probably will outperform bonds given the starting point. Like in our strategic asset allocation models, we're slightly overweight equities and underweight fixed income, whereas in our tactical models, we're overweight bonds or parts of the bond structure and underweight equities tactically. Look, that's for retail clients. So we don't trade that around every week or every month. We maybe make 2 or 3 trades a year and we're slow moving in that regard. And I think that's what most individual investors should be doing. They shouldn't be trying to day trade anything and looking for the moonshot stock. I mean, maybe with your fund money, sure, but your asset allocation should be relative to the last 20 years, should be more overweight stocks, less overweight bonds. For sure. Probably have some other hybrid-type assets that can do well in an inflationary environment like real estate, commodities, some of the international markets, which are much, much cheaper and are typically levered in a more positive way to higher prices. So those would be some of the things that would be different from the last 20 years. The last 20 years has been a disinflationary world, which means you want to own long-duration growth stocks, right? The longest duration thing you could stomach, long-duration bonds, and very little commodities, very little things that are inflationarily driven by inflation, but more driven by the cost of capital. And so now it's the exact opposite, right? You need to be involved in things that generate real cash flow today in addition to tomorrow that can be a variable income stream, that can grow with inflation. And that's not a bond and that's probably not long-duration growth assets that are still overpriced. Now, eventually they'll get cheap enough, but not here.

You covered a lot of ground in a short amount of time, and I don't want to keep you longer than I have to. I know you're busy. Is there anything I neglected to ask you that is on your mind, or you think we've got it covered in terms of your thesis?

No, I think that's pretty much it. Well, I guess what I really want to make clear though, because there's probably a lot of individual investors listening to this, we're not here to try and catch the very low. What we're trying to do is protect people from adding risk at the wrong time, and that's what people have been doing, right? So at 3,500, nobody wanted to touch anything. And now at 4,100, they're starting to get interested again.

Preston Pysh: And some of the junkier stuff has been running up the most.

Lawrence Lepard: Correct. Don't chase the dreams. Okay? Be disciplined on your entry points. This bear market is a cyclical bear market. This is not a structural bear market like the '70s. So we're not as pessimistic perhaps as some people try to make us out to be, but we are laser-focused on risk-reward and We're disciplined around that.

Thank you, Mike. Coming up, we're going to hear from someone who says if you're worried about an earnings decline, if you're worried about a recession, what you should be buying right now are dividend-paying stocks. That's next after this quick break.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you.

Morningstar, where data speaks. Welcome back. Meta, should we get to our conversation? I'll give you two choices. We do the conversation I had about dividend investing, or I could do probably like a 45-minute rant about how some people pay for memberships at nice health clubs to be able to use the basketball court in winter, but then all the pickleballers, because there's like a pickleball— Yeah, I'll do the first option. But they're moving in, Meta. They're taking over. I'm just saying.

But I think option A, please.

All right, well. What I hear you saying is you want to, you want to do this another week. You want to hear more about the pickleball, but you just like— let's do a pickleball special next week sometime when we can really flesh it out. Jackson is back and we can do that next week. Okay, got it. Yeah. Well, in that case, you heard Mike a little while ago say that he thought that earnings for U.S. companies would come in well below what Wall Street expects. I spoke recently with Alastair Pinder. He's a U.S. stock strategist UBS, and the view there is similar. They think earnings are going to be well below consensus estimates, but Alistair says that even though that's the case, you don't need to be so concerned about dividend payments. They're going to hold up better than earnings. Let's hear part of that conversation. I'm really intrigued by this piece of research on dividends that you've put out here. You make a case for dividend stocks now. What makes dividend stocks particularly attractive at this moment?

So I think there's 4 key reasons why we think dividend stocks are attractive in this moment in time. The first is that we kind of see them as a factor which is resilient in a number of macro scenarios. So we think they're resilient if we have a recession. They've typically outperformed by 4.5% in prior recessions. We also think that they're going to do well in sort of sticky inflation, I like the way you said it first, stickyflation.

That's a new one.

Go ahead. And tighter financial conditions. So even if we have a sort of soft landing scenario, I think dividend stocks will hold up relatively well. So I think they've got a good risk reward at this point. Now, the second reason why we like them is because of the fact that they are pretty cheap. So they trade at a 15% to 20% discount versus the market. So we think they're pretty attractive from that perspective. And the third reason is because— and I think this is actually something that surprises a lot of people— is that I think there's going to be a lot of dividend resilience. So our forecast is that the S&P 500 will see earnings down 11% this year, but we expect dividends to grow by 1%.

Let me just pause you there. Your firm sees earnings for the S&P 500 down 11%. Correct me if I'm wrong, That's not a consensus view, right? That's— in other words, you're a little more bearish on earnings than the rest of Wall Street.

Yeah, that's right. And part of that view is because, you know, our house forecast is that we're going to see a recession going into Q2. And so that leads us having a more negative view on the earnings. And it's also driven by the fact that we see a lot of pressure on margins as well. You know, we still think that the wage inflation, the inflation pressures, the fact that margins are very elevated, means that there'll be some rollover then, and that's going to squeeze earnings quite a bit.

Okay. So your reason number 3 then was that dividends tend to fare better than earnings in that environment?

So yeah, there's 2 reasons for that. One, if you just plot the chart of dividend growth and earnings growth, dividend growth is much less volatile. So that's great, first of all. Second, if you look at the payout ratio for the S&P 500, it's near record lows. So we see, you know, potential upside for the payout ratio moving towards long-run averages. It already moved a little higher in 2022. We expect more catalysts for it to go higher, things like the buyback tax. That should all be incrementally supportive. And so that should mean that dividend growth is resilient despite earnings being pretty weak.

Okay. And you had said there was a fourth reason.

Yeah, the fourth reason goes back into what I just mentioned at the end there, which is to do with sort of the incentives for allocating towards dividends right now. And so the buyback tax is, I think, you know, an important reason for companies to start allocating their capital return towards dividends instead of buybacks. And, you know, something that we saw in the current earnings season, which I think is really important to mention, is that companies that beat on dividends and earnings got a much better outperformance on the day than companies that just beat on earnings. So If you're beating on dividends, you are outperforming the market expectation, you're raising dividends more than expected, the market's rewarding you for that. And so I think that's another reason why companies may be incentivized to allocate more of their capital towards dividends at this point.

If this view on dividends kind of revolves around the possibility that earnings could disappoint, that we might be headed for a recession, what about just in good times, if we look out over the next 10 years, how important are dividends in general to stock investors today? There's this perception because we came through 10 years of growth stocks outperforming and there's this perception out there, maybe among younger investors, maybe among many kinds of investors where they'd say, well, wait a second, if a company has really exciting things to spend their money on, why would they pay out a dividend? What I should do is buy the company. That's the crypto metaverse electric vehicle autonomous company that's just spending all of its money on growth. Are dividends in general important for long-term investors?

Definitely. They're definitely important for long-term investors. I mean, if you look over a very long-term horizon, 20, 30 years, you know, those dividend compounders have been, you know, excellent companies and outperformed strongly. You know, if you take the, the growth stocks also, you know, some of the most exciting or better growth stocks over the last 10 years, sure, they haven't been doing the most amount of dividends, but they have been doing buybacks. So they've been returning their cash to shareholders in one form or another. And we think, as I mentioned, there's just going to be a shift in that return of capital away from buybacks towards dividends. Why? Well, I mean, I think the buyback tax is an important factor. And so I think that's going to create incentives towards moving that. I think you see there's a lot of political pressure at this moment towards companies who have been doing buybacks. And, you know, as we've been seeing at the moment, you know, markets are rewarding companies for providing dividends from, you know, just a performance perspective as well. So I think there's a number of reasons why they would do that. And, you know, the other thing on your point about, you know, dividends, are they attractive for the long run? I mean, I think if you just go for the pure highest yielding dividends, you know, which kind of sticks you into some utilities and telecoms. Like, sure, they're not that exciting, definitely, I would agree with that. But, you know, what we looked at was, well, where do we have companies which can provide a good dividend yield but also provide dividend growth? And companies or sectors that stood out were energy, semiconductors, and consumer durables and apparel. You know, some of them are growth stocks, particularly the semis. There's a good mix and some exciting, you know, areas of the market to be invested in there.

What are the kind of attributes you would look for if you want to screen for the right kind of dividend stocks to hold now? Would you start with the industries that you mentioned, or would you start with some company characteristics that bode well?

So I think if you look at the characteristics which bode well, you kind of get tilted into certain industries naturally. One of the screens that we highlighted in the report was that We like dividend yield and quality most importantly, because that's where we've seen some of the cheapest valuations, but also the biggest potential for dividend growth, given that payout ratios typically are relatively low despite already offering a high dividend yield. So we see potential dividend growth there.

And when you say quality, what is the way that one would screen for quality?

Great question. We're looking for companies with high return on equity, resilient and, you know, significant margins, low debts as well, you know, they're the kind of factors that we're looking for. If you look at it from that perspective, what sectors, you know, do you sort of get skewed towards? Well, you know, in our area, you're kind of going towards industrials, energy, the consumer sectors, uh, you know, maybe, um, you know, some tech as well, healthcare. You know, you're actually avoiding some of the naturally highest dividend-yielding sectors like utilities and materials and communication services. So I still think you can get some very interesting dividend stocks inside some of the growthy areas of the market, as you were mentioning.

Thank you, Alastair and Mike, and thank all of you for listening. Jackson Cantrell is our producer normally. This week he couldn't be bothered to work, so Meta heroically stepped in and did the job for him. What do you think Jackson's doing right now?

He's counting his toes.

I mean, how many? How many does he have? You make it sound like it's a pretty big job. That's fodder for next week, I think. Got it. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. And if you listen on Apple, please write us a review. If you want to find out about new stories, new podcast episodes, You can join the fun— not really— and follow me on Twitter. It's @JackHough, H-O-U-G-H.

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