October 2008 Article-Lion,Bull & Bears- By Eduardo Porter

What’s been going on in the stock market hardly fits canonical notions of rationality. In the last month or so, shares in Bank of America plunged to $26, bounced to $37, slid to $30, rebounded to $38, plummeted to $20, sprung above $26 and skidded back to almost $24 on Thursday. Evidently, people don’t have a clue of what Bank of America is worth.

It is hard to believe that stock prices are being driven by a rational assessment of value. Investors seem to be relying on the same primitive emotion that made our forebears on the savanna bolt when approached by a hungry lion: fear.
Of course, fear can be rational, as the experience with the lion might suggest. But the dynamics of the financial mess suggests that — on the way up and on the way down — investors, regulators, policy makers and homeowners have been operating by gut-driven nostrums rather than hardheaded analysis of facts. Behavioral economists politely refer to this as cognitively flawed heuristics.
The world is a complex place, so it’s understandable that we’ll try to master it by using simple rules. The problem is they are often wrong — like the incorrect yet popular belief that past behavior, say soaring house prices, is a good guide to future performance. Unable to make quantitative judgments about risky propositions, we often decide based on the best and worst possible scenarios regardless of their probabilities. That leads to binary decisions like going all in when the going is good and pulling out in panic when the tide turns.
These quirks are magnified by our well-known tendency to herd. We use other people’s behavior to validate ours — allowing ourselves to believe that housing is a good investment because our neighbor does.
There are such things as well-thought-out financial runs. The gyrations of the Bank of America stock might be caused by rational investors trying to puzzle out whether the bank will survive the crisis in good shape.
Even the rise and fall of American housing finance could be spun as a tale of flawless logic: homeowners and banks bet on reasonable forecasts that home prices would continue to rise. When they didn’t, defaults rose and banks became insolvent. Other banks ceased lending to them. Investors sold bank shares. The End.
I don’t think so. There is another big psychological distortion to account for: our tendency to believe our own theory of the world. Consider the former Fed Chairman Alan Greenspan’s repeated insistence during the housing price run-up that there was nothing to fear. Though he once warned about irrational exuberance, Mr. Greenspan lived by the belief that unfettered markets always lead to optimal outcomes.
“Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient,” he said in 2004. After the past few weeks, he might want to reconsider.

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Fed's dreaded 'taper' may not hurt after all

For all the hang-wringing on Wall Street about the Federal Reserve's expected " taper," you'd think the central bank was considering a ban on helicopter flights to the Hamptons.
Take a deep breath. For most of the rest of us, the Fed's "tapering" of its massive money flows into the U.S. economy could actually spell good news.
The "tapering" you may have heard about refers to a gradual easing up on the central bank's response to the financial collapse of 2008. Beginning in November that year, the Fed began buying up hundreds of billions of dollars' worth of  Treasury Bonds—along with dodgy mortgage debt—in exchange for cash that it conjured out of thin air.
Unlike you and me, the Fed can take a pile of debt, swap it for cash, and then hang onto that debt until it reverses the process later, which takes cash back out of the economy. The idea is to fine-tune how much cash is out there: More money makes it cheaper (interest rates go down) less money makes it more expansive (rates go up.)
It's been doing this—routinely—for decades. But the scope of this buyback—close to $4 trillion and counting—was anything but routine. Now, more than four years after the Great Recession ended, the Fed wants to get back to a more routine interest rate policy.


That's a long time for an "emergency" policy. Why has it kept the money machine going for so long?
Unlike past rebounds that saw the economy snap back like a rubber band, the recovery from the Great Recession has been very different. This time, the rubber band snapped completely during the financial collapse of 2008.
None of the periodic banking and market calamities since the Great Depression has done anything like the 2008 damage to the global financial system. Even today, credit is still hard to get for many small businesses and potential home buyers, two major drivers of economic growth.
That's another reason the Fed wants to wrap up its epic money-making policy: It may no longer be working. Despite the trillions it's pushed into the system, much of it hasn't reached the broader economy.
So where did all that money go? It had to go somewhere, right?
Much of it went to fill the giant crater left in the banking system's books after the industry's wildly reckless spree of bad mortgage lending. Today, U.S. banks' balance sheets are in much better shape, and they're sitting on big piles of reserves. (In Europe, where the central bank took a much more conventional approach to the crisis, banks are in much worse shape. So is the European economy.)


Some of the cash has helped push global stock prices higher but not directly: The Fed bought bonds, not stocks. This year's 25 percent market rally has been fueled by the record low interest rates the Fed has engineered by soaking up so much debt.
Those low interest rates on relatively safe assets like bonds forced investors to look for higher returns in riskier places like the stock market. Now, if the Fed reverses course and interest rates start to rise again, a lot of the cash flowing into the stock market will likely find a happy home in the bond market. That could turn this year's stock market rally into a next year's market rout. Which is why Wall Street has so dreaded "The Taper."

Who else loses if interest rates rise?
Home buyers—and sellers—could also lose. Earlier this year, after a brief mention by Fed Chairman    Ben Bernanke that The Taper was probably coming in 2014, mortgage rates shot up by a full percentage point in a month. They're still under 5 percent for most borrowers, but if they go much higher, the slow but steady recovery in the housing market could get a lot slower.


Higher rates aren't good for business investment either. Small business owners, who generally get a loan from a banker to buy new equipment or open up a new office, would have to pay more on those loans. Bigger businesses would have to pay higher interest rates on the corporate bonds they sell top investors to raise cash.
Many of the biggest U.S. corporations, though, are already sitting on large piles of cash they raised when money was so cheap. Still, while they may be able to grow their business with their own money, their profits would still be under pressure if higher rates put a crimp in their customers' spending plans.

So why would the Fed cut back on all this money if it puts the recovery at risk?
The job of the Federal Reserve has always been to take away the punch bowl when it felt like the party was in full swing. But since 2008, the Fed has replaced the punch in the bowl with grain alcohol. There's little evidence this party is getting out of hand—yet—but Fed officials are eager to get back to serving more conventional refreshments.
The main worry is that the $4 trillion pile of newly created cash will feed another bubble—whether in the stock or housing markets—that leads to yet another collapse. Fed officials have said they don't see evidence of that. But they've also conceded that financial bubbles are very difficult to spot until its too late to deflate them safely.

Bernanke and his colleagues have also made clear that "tapering" means just that: The flow of cash won't end abruptly. If interest rates suddenly spike, or if there are signs the economy is slowing again, they can always open up the spigots and restore the flow of money.
Much of the impact likely will be psychological: The Fed figures if the policy change is gradual enough, the impact will be muted. That's why it began signaling it's timetable—pegged to the unemployment falling to 6.5 percent—late last year. With the jobless rate now at 7 percent, we're getting close to that target.
And as long as inflation remains "anchored" at low levels, the Fed's policymakers have said they're inclined to use other more conventional means to keep interest rates low.
If their timing is right, the recovering job market will finally begin gathering more momentum on its own. Lower unemployment adds more steady paychecks to the economy, providing a much more sustainable flow of money into the economy than the Fed's bond buying. As that added consumer spending feeds demand, more companies can expand and hire more workers, adding more paychecks—and the cycle continues.
Or at least that's what the central bankers are hoping.
 

Ways to Profit From Dividend Stocks

Lately it's been hard to go wrong with dividend-paying stocks. Many companies are being generous with their payouts, and their stocks have generally performed well. But if your dividend holdings look a lot like your Grandma's—perhaps a smattering of utility and consumer-staples stocks—it's time to update your strategy.
One reason to revamp your approach: Some of the more traditional dividend-paying sectors, such as utilities and telecom services, may fare poorly when interest rates rise. What's more, income-starved investors have been snapping up higher-yielding stocks, leaving many of these shares looking pricey. And investors who limit their dividend hunt to the usual suspects are overlooking some companies with great dividend-growth potential. Some stocks that Grandma never dreamed of buying—including many technology companies—have become reliable dividend payers.
Here are eight ways income investors can profit from dividend stocks.

Don't Reach for the Highest Yields

Income-focused fund managers who have a lot of flexibility to invest in stocks, bonds and other asset classes have lately made some big moves toward dividend-paying stocks. But they're largely focused on finding future dividend growth, not the highest current yield.
Technology, energy and materials stocks, for example, don't always have the juiciest yields. But they offer better dividend-growth potential—and more reasonable valuations—than higher-yielding sectors such as utilities and real estate investment trusts, money managers say.
One mutual fund that's focused on high-quality companies committed to growing dividends over the long haul is Kip 25 member Vanguard Dividend Growth (symbol VDIGX). It may not have the highest yield in its category, but its total returns have outpaced about 95% of large-blend fund rivals over the past decade.

Look for Steady Dividend Growers

The strategy is simple: Buy stocks that regularly boost their dividends and hold for the long haul. You can screen stocks for companies that have raised dividends consecutively for, say, five or ten years. These stocks don't necessarily pay superhigh dividends. But current income isn't the point. Rather, the idea is to target companies whose share prices rise steadily along with their dividend streams. If the strategy works as you expect, you could earn a handsome yield based on the price of your initial purchase.
You can see how dividend growth and share-price appreciation work together by looking at McDonald's(MCD). In 2001, Mickey D's paid out 23 cents a share in dividends on a stock that averaged about $30 a share, for a yield of 0.8%. In 2002, McDonald's raised its annual dividend to 24 cents. Then the company's fortunes improved, and McDonald's decided to give more generously to its shareholders. By 2006, the rate was $1 per share. After a 15% boost in November 2011, the Golden Arches paid dividends at a rate of $2.80 a year. The dividend rose 1,100% since 2001, or 28% annualized over that ten-year span. If you had bought McDonald's stock at $30 per share in 2001, the yield on that original purchase would have worked out to 9.3%. (McDonald's, recently selling for $98 a share, continues to hike its dividend: The company announced recently that the annual payout will be boosted to $3.24 per share.)

Watch Out for Rising Rates

You already know that rising interest rates can hurt your bond holdings (as yields go up, prices go down). Rising rates can also be tough on dividend-paying stocks, which have to offer higher yields to stay competitive as bond yields climb. But some dividend sectors are more vulnerable than others.
Morningstar recently studied rising-rate cycles in which the monthly average ten-year Treasury yield rose one percentage point or more from its low point. In seven such cycles since 1992, the broader market trounced dividend payers, with Standard & Poor's 500-stock index posting an average total return of 11%, versus 3.7% for the Dow Jones US Select Dividend Index.
The market's most defensive sectors, such as utilities and telecommunications, have generally fared the worst, Morningstar found. One reason: Rising rates tend to coincide with stronger economic growth, which favors more cyclical, growth-oriented sectors such as technology and industrials.

Think Outside the Box

The biggest contribution to the S&P 500's total dividends now comes from a sector that hasn't traditionally been known for big payouts: technology. Buoyed by plenty of free cash flow and strong balance sheets, tech giants such as IBM (IBM) and Microsoft (MSFT) can continue to raise their dividends, money managers say. Other tech names favored by analysts and fund managers include Intel (INTC) and Apple (APPL).
For fast-growing dividends and relative resilience amid rising rates, investors should also look to financial stocks, managers and analysts say. After spending years working through financial-crisis hangovers, many banks are now getting back to the business of raising dividends.

Get in on the Ground Floor With Dividend Rebuilders

Investing in companies that are restoring their payouts is a sound long-term strategy. If you buy shares that pay a small dividend, the yield on your original investment can soar if the company boosts the rate. And because rebuilders formerly paid high dividends, you can be confident the bosses are willing to share the wealth once the exchequer permits them to.
One sector in redevelopment: financials. Dividend investors still bitter about financial stocks' sharp dividend cuts during the financial crisis may find it's time to forgive and forget. Many banks are now boosting payouts. With a current quarterly payout of 30 cents per share, for example, Wells Fargo's (WFC) dividend has bounced back near pre-crisis levels.
Higher long-term interest rates can weigh down mortgage originations, a big source of fees for many banks. But as shorter-term rates start to rise, banks can profit by charging higher rates on many loans while still paying near-zero interest on a large base of customer deposits.

Scout the Rookies

When a company offers a dividend for the first time, it generally means that business is going gangbusters and there's so much extra cash that it makes sense to toss some back to shareholders. Dividend rookies aren't necessarily small-fry companies. Recent dividend initiators include big names, such as Dunkin' Brands (DNKN) and Apple, which started paying a dividend in 2012 and raised it in 2013.
One word of caution: A dividend launch is not always good news. It could mean that a company's growth has slowed and that its prospects have dimmed so much that the bosses have no better idea for what to do with the money than give it back.

Venture Overseas—Carefully

Foreign stocks in both developed and emerging markets tend to offer more enticing dividend yields than U.S. companies. In the energy sector, for example, some fund managers favor the richer yields of oil giants Royal Dutch Shell (RDS.A) and Total (TOT) over U.S. competitors, such as ExxonMobil (XOM).
The higher yields come with some potential pitfalls for U.S. investors. Many countries withhold taxes—often 10% to 20%—on dividends paid to U.S. shareholders. If you hold the shares in a taxable account, you can recover that money through the foreign tax credit. But if you hold the shares in an IRA or other tax-deferred account, you can't claim the credit.
Currency swings can also make for rough seas when dividends aren't paid in U.S. dollars. Many mutual funds hedge away at least some of this foreign-currency exposure, smoothing the ride for investors.

Dissect Dividend Funds' Strategies

When sifting through dividend-focused mutual funds and exchange-traded funds, consider whether the fund is more focused on high-yielding stocks or on shares with more moderate yields and strong future dividend-growth potential. Funds in the two camps are likely to have very different portfolios.
The iShares Select Dividend ETF (DVY), for example, tracks an index that selects stocks based on dividend yield. That approach has lately led to a hefty concentration in the utilities sector. If you're looking for dividend growth and broader diversification, consider a fund such as Vanguard Dividend Appreciation ETF (VIG), which focuses on companies that have raised dividends for at least ten consecutive years.

Warren Buffett & Bill Gates on the Markets, Interest Rates, Equities

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