Week 267 - Interesting Q3 Stock Picks From Merrill Lynch

Situation: At the beginning of each quarter, Merrill Lynch picks 10 stocks (often including two “shorts” to bet against). I have come to respect their picks but rarely act on those. Why? Because they are, for the most part, risky companies in risky industries. But when the Q3 picks came out on June 30, I was startled. Most of the picks are Dividend Achievers, i.e., companies with a record of increasing dividends for 10+ yrs. As the industry leader, with $2.2 Trillion in client assets under management, Merrill Lynch is encouraging its clients to make defensive investments. They see a Bear Market coming.

Mission: Highlight reasons to expect a Bear Market, and analyze the recommendations by Merrill Lynch.

Execution: The US economy is on solid footing. Jobs are becoming more plentiful, and wages are climbing faster than inflation. The unemployment rate in June 2016 was 4.9% (vs. 4.6% in June of 2006). However, labor market participation (62.7% in June 2016) hasn’t returned to it’s high from 10 yrs ago (66.2% in June 2006). When those who are underemployed (i.e., part-time workers), and those who are out of work but too discouraged to look for jobs, are added to the officially unemployed (i.e., job seekers), the “U-6” unemployment rate for June 2016 was 9.7% (vs. 8.4% in June 2006). Another problem is that many of the jobs that had been available to those without a college education, and paid well enough to allow those workers to become homeowners, have disappeared. The Information Revolution is replacing the Industrial Revolution but beneficiaries need to have a 4-yr college degree in math, science, engineering or technology to participate fully.  

On a global scale, the US economy is an outlier. No other economy can be said to have recovered from the Lehman Panic. Great Britain was recovering but now faces recession due to fallout from Brexit. The rest of Europe is mired in economic troubles mainly caused by an over-reliance on debt financing that cannot be resolved without increases in productivity through education, “creative destruction” of outmoded industries and employment practices, automation, and increased free trade to leverage its competitive advantages. China has an “800 pound elephant in the room” called State-Owned Enterprises. Those continue to grow through municipal borrowing despite the best efforts of China’s economic leaders. Japan has found no way to emerge from decades of recession. Brazil and Russia are in deep recessions. India and South Africa are on growth trajectories but remain mired in structural unemployment. The “Arab Spring” unleashed unimaginable levels of discontent that remain poorly understood but affect the entire globe. The economies of those countries will remain in stasis until political solutions acceptable to those populations can be implemented. What is the “root cause” for underperformance in so many regional economies? Experts point to modern communications, like social media. Anyone with access to a cell phone, laptop or TV is a candidate to develop a more materialistic lifestyle, by whatever means necessary. 

We don’t know how the next Bear Market will be triggered, so the S&P 500 Index continues to make new highs driven by ever-lower interest rates. There are many candidates, overvaluation being prominent among them, with the S&P 500 Index sporting a P/E of 25. Growth of the US economy (GDP) faster than 3%/yr could cure that problem but it doesn’t appear to be happening. Perhaps our government agencies, our corporations and our households have borrowed too much money, and interest payments consume too much of those budgets to allow enough investment in growth. There is also too much uncertainty about the future, so companies are reluctant to move forward with hiring and expand operations. No one issue, whether Brexit or the upcoming US election, has the capacity to trigger a recession on its own. But the above-mentioned points will amplify any crisis atmosphere that arises out of a destabilizing event like a natural disaster, a nuclear accident, or a civil war.  

Administration: The Merrill Lynch Q3 recommendations include two candidates for short sales and a company that recently went public. We’re not interested in those. But do check out the other 7 (including 6 Dividend Achievers) that are worth a look by anyone seeking “buy-and-hold” stocks for a retirement portfolio (see Table). 

Bottom Line: Merrill Lynch analysts apparently think a Bear Market is coming soon, and have advised clients to pick stocks that are likely to hold value in such an environment. Seven appear suitable as long-term holdings (see Table). Six of those are Dividend Achievers: NextEra Energy (NEE), Realty Income (O), AT&T (T), Raytheon (RTN), Walgreen Boots Alliance (WBA) and Lowe’s (LOW). The non-dividend paying stock, salesforce.com (CRM), is the seventh and has growth prospects that could support continued price accumulation in a recession. However, our analysis suggests that only NEE is worth buying when the market is overheated (see Table).

Risk Rating: 6 (Treasuries = 1 and gold = 10)

Full disclosure: I dollar-average each month into NEE and T.

NOTE: Metrics are current for the Sunday of publication. Red highlights denote underperformance vs. VBINX at Line 13 in the Table. Net Present Value inputs are described and justified in the Appendix to Week 256. Briefly, Discount Rate = 9%, Holding Period = 10 years, Initial Cost = the moving average for stock price over the past 50 days (corrected for transaction costs of 2.5% used to buy ~$5000 worth of shares), Dividend Growth Rate is Dividend CAGR for the past 16 years, Price Growth Rate is the mean Price CAGR for the past 16 years (http://invest.kleinnet.com/bmw1/), and Price Return for selling shares in the 10th year is corrected for transaction costs of 2.5%. The NPV template is found at (http://www.investopedia.com/calculator/netpresentvalue.aspx).

Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com