Twenty-nine out of 30 isn’t too shabby. The Federal Reserve released the results for its latest stress tests, and 29 out of America’s largest 30 banks met their required capital requirements. Only Zions Bancorporation (ZION) — a relatively small player — failed to make the cut.
Credit-card issuer Discover Financial (DFS) received a clean bill of health and responded much as its shareholders might have hoped — by raising its quarterly dividend 4 cents to 24 cents per share.
It’s been a rough couple of years for bank investors. After the 2008 meltdown, the government wanted to make sure that it would never be forced to bail out the financial sector again, or at least not on the scale we saw in 2008. As a result, banks have been forced to reduce leverage, maintain much higher levels of high-quality capital, and — as a means of conserving cash — refrain from making dividend payments or share buybacks.
So, with the Fed’s stress test out of the way, can we expect to see wholesale dividend hikes across the financial sector?
Maybe. We’ll find out soon — the Fed has an announcement planned for this afternoon.
“U.S. banks will tell shareholders on Wednesday how much they plan to pay out after the U.S. Federal Reserve unveils whether they can afford the cost and still be robust enough to weather the next crisis,” Reuters reports. “It is part of a two-step annual regulatory check-up of the health of the largest U.S. banks. Last week, the Fed said that all but one of 30 banks had passed a model run of a simulated crisis similar to 2007-09 credit meltdown.”
The Fed has been pretty good at playing its cards close to the vest. But based on the results of the stress test, we can handicap the odds that they will allow a dividend hike on a bank-by-bank basis.
Let’s use Bank of America (BAC) as an example. The Fed found that BAC’s Tier 1 leverage ratio would fall to as low as 4.6% under the “severely adverse” scenario , only slightly higher than the regulatory minimum of 4%. Still, with “excess” capital of about $13 billion, the consensus view is that BAC will raise its quarterly payout from one cent per share to 10 cents. Under this scenario, BAC would yield about 2.3% at current prices.
Citigroup (C) , which, like BAC, currently pays out one cent per share quarterly, is expected to raise its dividend to about five cents. At current prices, that would give it a yield of about 0.40%.
JP Morgan Chase’s (JPM) annual dividend is expected to rise from $1.52 per share to $1.67 per share, giving it a yield of about 2.8%.
If you’re buying a stock with the specific goal of generating income, none of these potential yields are going to be particularly inspiring. Though, at least in the case of JPM, the expected yield is higher than what you can expect from the 10-year Treasury.
This brings me to what I consider the single most important issue for any investor in or near retirement. If you want to keep up with inflation — even the modest 1%-2% variety we have today — you need your income stream to rise over time. Even a seemingly innocuous 2% inflation rate represents a loss of purchasing power of 22% over the course of a decade.
Standard financial planning will tell you that the solution is to maintain a sizable allocation to equities, assuming that you will sell off about 4% of your portfolio per year. At a 4% withdrawal rate, you can “safely” assume that you won’t outlive your assets.
Well, that sounds good. But there is one little problem with it. The market, as measured by the cyclically adjusted P/E ratio, is very expensive today at about 25 times a rolling 10-year average of earnings. Corporate profits are also at record highs, and inflation and interest rates are still very low and have little space to fall further. In this environment, do you want to bet your retirement on capital gains that may never materialize?
Some dividend growth strategies assemble a portfolio of stocks that offer a current yield that is competitive with competing income instruments (such as bonds) and — most importantly — offer a strong probability of rising dividends. Personally, I like to see stocks that have at least five consecutive years of rising dividends, and ideally I like to see that they have survived a deep recession with their dividend intact.
On this count, most banks currently fail to make the grade. Though as the sector emerges from years of government scrutiny and with cleaner, less-leveraged balance sheets, they’re now on my radar.
Photo Credit: wwward0
DISCLAIMER: The investments discussed are held in client accounts as of February 28, 2013. These investments may or may not be currently held in client accounts. The information in this material is not intended to be personalized financial advice and should not be solely relied on for making financial decisions. All investments involve risk, the amount of which may vary significantly. Dividends reflect past performance and there is no guarantee they will continue to be paid. Share buyback programs are typically temporary and should not be relied upon in the long term. Past performance is no guarantee of future results.