What happens when this 10% fully franked dividend yield turns to zero?

A plunging iron ore price smashes the S&P/ASX 200 Index, and once juicy dividend yields alike.

| More on:
a woman

So much for the “Christmas Rally.”

Overnight, although US markets again closed at new record highs, it was hardly the stuff to set pulses running…

US Markets 11th Nov 2014

Source: Google Finance

Still, who’s complaining?

The rise made it five straight days in a row for US markets, the longest winning streak since June… all of which prompted Abby Cohen at Goldman Sachs to predict the S&P 500 will climb to 2,150 a year from now.

All aboard Foolish readers… low interest rates combined with a recovering economy and strong corporate earnings all adds up to a rising stock market.

Or maybe not.

Here in Australia, in afternoon trade, the ASX is on the nose, again.

The punishment meted out to junior iron ore producers Atlas Iron Limited (ASX: AGO) and BC Iron Limited (ASX: BCI) has been particularly savage, both down another 10% today, the latter company now down 84% since February this year.

Talk about doing it tough… although its got nothing on mining services company WDS Limited (ASX: WDS).

That stock is down a whopping 30% today after further reducing its already reduced guidance from just one month ago. WDS is now predicting it will make a loss this financial year, is suspending its dividend policy, and won’t be paying a dividend at all.

Never truer is the old saying “if it looks too good to be true, it probably is.”

I’ll let you into a little secret…

Andrew Page, lead Advisor of our brand new advisory service Motley Fool Dividend Investor, recently tasked me with finding my Number One Top ASX Dividend Stock.

It was easier said than done, given the dividend yield had to be above 4%, fully franked, and I couldn’t fall back on the usual suspects of the banks and Telstra Corporation Ltd (ASX: TLS).

You know what? When I first started looking, WDS Limited was trading on a dividend yield of 10%. Based on my brief, it looked attractive. But I didn’t bite, my first line of defence being “it looked too good to be true.” And sure enough it was… WDS shares are down around 75% since they fleetingly made it onto my radar.

In this low interest rate environment, as judged by the overwhelming response to the launch of Motley Fool Dividend Investor, dividend investing is all the rage. And no wonder too… as you’ll read further down, interest rates are likely to stay low for a considerable time, maybe going even lower from here.

By comparison, when you add in the tax effectiveness of fully franked dividends, for income-hungry investors, buying dividend stocks is close to a no-brainer decision.

But there is a catch. Not all dividend stocks are created equal. A 10% historical dividend yield looks great, but when it turns to 0% and the shares plunge 75%, as happened to WDS Limited, all the tax effectiveness in the world isn’t going to save you.

It’s why my brief, and that of Andrew at Motley Fool Dividend Investor, is to absolutely minimise the downside risk.

Andrew would rather recommend a stock trading on a lower dividend yield and only partly franked than to stretch to the likes of WDS Limited or fellow mining services companies like MACA Limited (ASX: MLD) and even the darling of the sector, Monadelphous Group Limited (ASX: MND). The latter company is currently trading on a trailing fully franked dividend yield of over 10%!

It all reminds me of Warren Buffett‘s two rules of investing…

Rule #1: Don’t lose money.
Rule #2: Don’t forget rule #1.

You may have seen this headline in The Sydney Morning Herald

Savers stung

“Australia’s big banks are quietly making significant cuts to the interest rates paid on term deposits, as lenders compete less keenly for household savings.”

It’s a story I’m well familiar with, having recently received the dreaded email from my online “high” interest savings bank account…

 

TS 15 Oct 1

 

As you may have read, I’m not content to idly sit here and wait for interest rates to rise.

And I’m not going to sit here and do nothing.

I mean to say, how the hell are you supposed to live on term deposits paying a miserable 2.5%? On $100,000 — a substantial sum of money, your pre-tax annual interest is just $2,500.

Heck, I’ve spent $2,500 just in the last couple of weeks, some on those pesky bills, some on life’s little luxuries (a new iPhone 6) and a decent chunk on something completely unexpected — a replacement washing machine.

If it feels like you’re going backwards, it’s because you are. And things aren’t about to get better any time soon, as judged by The Sydney Morning Herald story.

After all, they don’t make washing machines like they used to, and the repair man ($110 call out fee) told me you’re doing well these days if a washing machine lasts five years.

It gets worse. Not surprisingly the plunging iron ore price has had a negative impact on the nation’s budget, a major factor in Canberra consultancy Macroeconomics saying Treasurer Joe Hockey’s budget has a $51 billion black hole.

That’s a few new washing machines. More importantly, it’s a BIG problem for our under-performing economy, especially given this government’s ‘budget surplus or bust’, ‘no new taxes’ and ‘no surprises’ election promises.

Given that, stating the obvious, in the face of falling revenue, in order to balance the books, the only thing this government can do is cut spending.

But here’s the problem… cut spending and you take money out of the economy. People spend less. Unemployment rises. Taxes fall. Benefit payments increase.

The time to take money out of the economy is during the good times. Instead, in a desperate attempt to buy their way to election success, politicians of both sides showered the mining-boom cash on us like it was confetti. By comparison, it makes Helicopter Ben Bernanke look like Uncle Scrooge.

Now just imagine what damage could be wreaked on our economy, and big Joe’s budget, if the iron ore price keeps falling…

According to investment bank Citi, it’s a very real possibility. Yesterday, they took the hatchet to their iron ore forecast, saying they expect prices to drop into the $US50s.

If anything like that would come to pass, expect total carnage for many of our junior iron ore stocks.

Come in Glenn Stevens. If fiscal policy can’t or won’t pick up the slack in the economy, it’s all down to monetary policy… and that means even lower interest rates.

t also means a substantially lower Aussie dollar. You better splash out on US stocks now, before it’s too late, book your overseas holiday, and stock up on cheap imports (perhaps I should buy two washing machines instead of one!).

The RBA has long been wanting a lower dollar, ideally around US80 cents. That will do some of the economic lifting for you, but if iron ore prices do fall as low as Citi thinks, it will likely still leave Australia running on empty.

I know what you’re thinking… what will even lower interest rates do to already over-inflated house prices? I’d expect any further cut in interest rates to come with macro-prudential measures, like tougher rules on housing loans.

Imagine the house price carnage if suddenly you needed a 40% deposit for foreign property buyers, a 30% deposit for investment properties, and a 20% deposit for first home buyers.

Imagine the outcry from the banks and the voters (and therefore the politicians).

Imagine how low the dollar could go.

I don’t wish to alarm. I’m happy to leave that to others. But it doesn’t take too much of a stretch to get to such a scenario.

On the bright side, an ailing economy, a housing bubble, a massive budget deficit, a weak currency and zero percent interest rates didn’t harm US stock markets. They’re riding at all time highs… meanwhile the S&P/ASX 200 Index is still light years away from breaching its October 2007 peak of 6,479.

Heck, even in the UK, an economic basket-case in comparison to Australia, the FTSE 100 is within sight of its all time high, last reached way back on December 30th 1999 — just before the Y2K millennium bug was supposedly about to bring down the global economy.

Ah, those were the days… when all we had to worry about was about whether the world’s computers could cope with the year moving from 1999 to 2000.

Wondering where you should invest $1,000 right now?

When investing expert Scott Phillips has a stock tip, it can pay to listen. After all, the flagship Motley Fool Share Advisor newsletter he has run for more than eight years has provided thousands of paying members with stock picks that have doubled, tripled or even more.*

Scott just revealed what he believes could be the five best ASX stocks for investors to buy right now. These stocks are trading at near dirt-cheap prices and Scott thinks they could be great buys right now.

*Returns as of August 16th 2021

Bruce Jackson has an interest in Telstra

More on ⏸️ Investing