The stock market is up over 40% from the March 23 bottom. This spectacular 50-day rise bookends the 33% market drop from mid-February to the March bottom. Overall, the S&P 500 moved by more than 70% in a little over three months, leaving many investors bewildered. But recent market action implies that most traders are expecting conditions to improve from here. Stimulus measures, reopening the economy, and hopes for a virus vaccine or treatment are all part of the recovery scenario. In this week’s commentary, we look at what is driving the case for both bears and bulls. We also discuss portfolio implications of the rising prevalence of “zombie” firms in the market.

But even though stocks seem to be forecasting recovery, we will not be throwing caution to the wind. A heightened focus on financially strong companies remains essential because profits and dividends are under pressure, and more firms carry higher debt loads today than in the past.

Profit and Dividend Contraction

According to FactSet Research, analysts expect S&P 500 profits to fall 43% in the second quarter. For the full year, expectations are for a 23% drop in profits. This decline also exposes some companies to dividend cuts. While it is impossible to predict which companies will cut, there are some tendencies worth noting.

Dividends tend to be “stickier” than earnings. So, we expect S&P 500 dividends to decline, but by only about 10-15%. Share buybacks can be suspended and restarted without much notice, and companies are more likely to curtail buyback programs before cutting dividends whenever possible. Hence, we envision larger cuts in share buyback programs than in dividends.

While it is impossible to predict which companies will cut or eliminate a dividend, we find that other factors can increase the odds of a dividend cut when profits come under pressure.

We find that firms with these characteristics can be far more likely to cut a dividend:

  1. below average profitability (income/assets)
  2. above average leverage (debt/capital)
  3. above average payout ratios (dividends/earnings)
  4. and above-average dividend yield (dividend/price)

During the 2007-2009 recession, far more dividend cutters fit the profile above. 40% of companies with the above characteristics at the end of 2007 cut dividends — twice the average rate for the overall market. Unprofitable, highly-indebted, high-yielding companies with poor dividend coverage are less likely to maintain dividends when the going gets tough. Dividend cutters also tend to generate lower total returns over time versus companies that raise or maintain dividends (Case for Rising Dividends).

Thus, when profits are receding, as is the case today, it is even more important to focus on companies with a high degree of financial flexibility.

Rising Debt and “Zombies”

It has been easy to pick winners during the past 50 days because every stock in the S&P 500 is up over that period. Unfortunately, this happy scenario is not likely to continue. It is far more likely, in our view, that the market begins a deliberate sorting-out process. Companies that need continuous debt financing or bailouts to operate are likely to be penalized in this process. These businesses should be avoided, especially if recovery is slower than expected, credit availability tightens, or interest costs rise. We think self-funding, conservatively financed, cash-rich businesses will fare better.

To wit, a growing percentage of companies are unable to cover interest costs from profits. More and more of these firms’ resources are absorbed in debt service and diverted away from productive investment and growth that drives long-run shareholder value. A 2018 study by the Bank of International Settlements labeled such firms “zombies.” These firms can remain in business for years but in a weakened state and dependent on easy credit access. According to the study, 16% of U.S. public firms are “zombies” today compared to 2% during the late 1980s. In a hyper-competitive world, “zombies” are vulnerable to challenges by younger, more financially nimble competitors. These firms often carry higher dividend yields but tend to carry higher risk and/or lower growth.

A decade of cheap financing contributed to conditions that created rising indebtedness. The result has been a rising debt service burden and a lessening of credit quality. The average ratio of net debt (debt-cash) to cash flow for the 3,000 largest public U.S. stocks has risen to 2.7x from 1.0x in 2007. Higher indebtedness can lead to greater losses for shareholders when business conditions falter.


So it is clear that while stocks are on a tear, we should continue to focus on reliable and financially flexible companies for two main reasons. First, we should keep the focus because declining profits make dividend cuts far more likely for weak and leveraged firms. But most importantly, because a decade of easy monetary conditions has left many firms with high debts and weakened balance sheets.

And what if we are wrong and things recover faster and more completely than we currently expect? In that case, the bull run might run further and farther than we now expect. If that happens, we will take comfort in knowing that Washington Crossing’s portfolios are invested in the highest quality businesses we can find at valuations we find to be reasonable.


The Washington Crossing Advisors’ High Quality Index and Low Quality Index are objective, quantitative measures designed to identify quality in the top 1,000 U.S. companies. Ranked by fundamental factors, WCA grades companies from “A” (top quintile) to “F” (bottom quintile). Factors include debt relative to equity, asset profitability, and consistency in performance. Companies with lower debt, higher profitability, and greater consistency earn higher grades. These indices are reconstituted annually and rebalanced daily. For informational purposes only, and WCA Quality Grade indices do not reflect the performance of any WCA investment strategy.

Standard & Poor’s 500 Index (S&P 500) is a capitalization-weighted index that is generally considered representative of the U.S. large capitalization market.

The S&P 500 Equal Weight Index is the equal-weight version of the widely regarded Standard & Poor’s 500 Index, which is generally considered representative of the U.S. large capitalization market. The index has the same constituents as the capitalization-weighted S&P 500, but each company in the index is allocated a fixed weight of 0.20% at each quarterly rebalancing.

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