This week the Toronto Globe and Mail–Canada’s paper of record–announced the country’s stock market had fallen more than 20 percent from its previous high point. The editors’ conclusion: Canadian stocks are now officially in a bear market.

You won’t find many on this side of the border who would disagree. That’s because US investors’ losses have been magnified by a nearly 10 percent retreat in the Canadian dollar. And because Canadian stocks’ dividends are paid in Canadian dollars, the falling loonie has also cut into payouts’ US dollar value.

Despite a stronger banking system, superior trade balance, a near balanced budget and now a higher (AAA) credit rating than the US, Canada has found itself a victim of global de-risking.

Risk-fearing investors have dumped its stocks and bonds, just as they have virtually every other income investment in the world. And they’ve put their cash into the very asset whose downgrade by Standard & Poor’s kicked off this so-called bear market: US Treasury bonds.

The yield on the 10-year US Treasury note was already at a low 2.5 percent rate before the credit rater made its move. Since then, the more worried investors have become about global credit and economic pressures, the more they’ve poured into Treasuries of all stripes. The upshot is the 10-year has sold at a yield of less than 2 percent for better than a month, and rates on other Treasury securities are at historic lows as well.

For many years conventional wisdom has been that low and falling Treasury yields are good for income investments across the board. That’s because the 10-year yield has long been considered a benchmark interest rate for everything from dividend-paying stocks to junk bonds.

According to the theory, when benchmark interest rates fall, investors demand less yield on other income investments, and prices rise for everything from dividend paying stocks to junk bonds. Conversely, when benchmark rates rise investors should demand a higher yield on riskier fare, and prices fall for income investments across the board.

Ironically, this link has been busted for at least a decade. In spring/summer 2003, 2004, 2005, 2006 and 2007, the benchmark 10-year Treasury note yield did spike up and trigger income investment selloffs. Those were reversed later in the year as rates backed off temporarily, only to rise again the next year.

Dividend-paying stocks and other income investments, however, finished each of these cycles on higher ground. Meanwhile, the benchmark 10-year Treasury note finished each cycle on lower ground, with the yield ratcheting steadily upward to peak above 5 percent in both 2006 and 2007.

The talk then among many cognoscenti was of a spike well above 5 percent and a new permanent trading range there. And the implication was that yield-paying fare would suffer. Yet income-paying stocks such as utilities, master limited partnerships and even Canadian stocks–despite the announcement of the trust tax Halloween night 2006–continued to ratchet higher.

That was the first indication so-called benchmark interest rates were no longer calling the tune for other income investments. The second indication was far more jarring.

In barely 10 weeks from the middle of October 2008 to early January 2009, the 10-year Treasury yield dropped from well north of 4 percent to barely 2 percent. But rather than rally, almost every other income investment suffered its worst beating since the 1930s. Even stocks that increased dividends were pounded and near-term investment-grade company bond yields soared to high single-digits.

The 10-year yield bottomed several weeks before the stock market did in March 2009. But its surge back to the 3.5 to 4 percent range corresponded with one of the prolific rebounds in stock market history.

The Flash Crash and European sovereign debt crisis interrupted stocks’ upward progress in mid-2010, at which time Treasury rates plunged back toward 2.5 percent. The calming of those worries by autumn, however, reversed both markets’ course once again. The 10-year yield began rising again, nearing 4 percent by late spring.

That low price/peak yield corresponded with highs for the cycle in virtually every other income investment. And thus was the stage set for this year’s historic rally in US Treasury securities, and plunge in almost everything else.

New Rules

Clearly, the old rules no longer apply for valuing income investments. In fact, anyone placing serious bets in recent years on the theory of “interest rate sensitivity” would have been broke many times over.

That begs the question what is really been driving income investment valuations? More importantly, how long will it continue, and how can we take advantage?

The answer to the first question, simply, is risk. More specifically, investor perception of risk has been driving this market. Benchmark interest rates are historically low, but they’re also as volatile as they’ve ever been. And whether you’re talking about recession-resistant utilities or higher-risk junk bonds, the same holds true for almost every other income investment this side of cash.

All income investments are being directed by investor perceptions of risk. And in this environment the sentiment seems to change by the hour, as investors respond to every piece of news or even comments by those considered to have the inside scoop.

Under the new rules, income investments are constantly being priced and re-priced by perceived threats to the dividends and interest they pay. Prices rise and fall as perceived risks wane and wax, respectively.

I can’t help but chuckle every time I look at how low Treasury yields are now, given the level of hyperbole before S&P’s August downgrade. At the time, the mediocracy was screaming about how Treasury yields would spike and carry all other rates up with them. Instead, Treasuries have staged their greatest rally in history, and corporate borrowing rates are still at their lowest levels ever.

Uncle Sam’s debt is still clearly global investors’ market of last resort when panic sets in. That’s both for the fact there’s no real risk US Treasuries won’t pay interest owed and because they form the only market large enough to absorb such a major inflow of cash.

What goes in due to fear, however, will come out when tensions calm. That’s one reason why US Treasuries are truly a lousy investment for us regular income investors. The other is yields now are extremely paltry. And again that’s because investors perceive so little risk to interest being paid.

No other income investment comes up to Treasuries in terms of dividend security or liquidity. As a result, everything from water utility stocks to high-yielding Canadian energy producers should logically be priced higher.

How much higher, however, is what sets prices. And that depends on investor perception of risk to dividends.

In US dollar terms everything paying dividends or interest in Canadian dollars has lost ground in 2011. In my view, that’s a temporary reaction to global turmoil that will soon be reversed, as credit/economic fears diminish from current elevated levels over the next few months.

Looking behind the currency effect, however, there’s a clear separation between stocks in the Canadian Edge How They Rate coverage universe. On the one hand are stocks like Conservative Holding Keyera Corp (TSX: KEY, OTC: KEYUF) that haven’t budged during the crisis. In fact, Keyera hit a new all-time this month, and the stock still trades well above my buy-under price of USD38.

On the other hand, companies like Just Energy Group Inc (TSX: JE, OTC: JUSTF) have lost nearly a third of their market value this year, with most of the drop in the last two months. That’s despite posting robust numbers, closing a key acquisition in Texas and recently issuing guidance that full-year fiscal 2012 results will beat its prior projections. (See Portfolio Update.)

Companies that really are struggling have fared worse still. Natural gas producers like Perpetual Energy Inc (TSX: PMT, OTC: PMGYF) have lost nearly half their value this year, as the price of the clean fuel has plunged to a multi-year low of barely USD3.50 per million British thermal units.

Worse, Yellow Media Inc’s (TSX: YLO, OTC: YLWPF) near total demise has raised fears that every dividend-paying, non-energy company is vulnerable to complete collapse. That company eliminated its dividend last month as it was forced to acquiesce to what amounted to a giant margin call from worries lenders. (See Dividend Watch List.)

How They Rate provides a snapshot of what the risk perception curve looks like overall in the Canadian Edge coverage universe. Yields range as high as nearly 18 percent for Superior Plus Corp (TSX: SPB, OTC: SUUIF). Two-dozen stocks more yield at least 10 percent.

These stocks are clearly pricing in dividend cuts. So arguably are another couple dozen stocks that yield between 8 and 10 percent.

Yields like these were nowhere to be found just a few months ago. In fact, you’d have been hard pressed to find any companies yielding more than 10 percent. The fact that prices have fallen and yields have risen so far, so fast has little to with actual developments at companies. Since July 2011, the only companies in How They Rate to cut dividends have been extreme cases, namely Armtec Infrastructure Inc (TSX: ARF, OTC: AIIFF), New Flyer Industries Inc (TSX: NFI, OTC: NFYIF) and Yellow Media, which cut twice.

The table “Dividend Growers: How They’ve Fared” arrives at the same conclusion from another side, namely the stock price performance of How They Rate companies that have increased dividends at least once over the past 12 months.

In the short run, dividend-paying stocks’ prices respond to almost anything, most of which has nothing to do with the health and growth of the underlying business. Over the long haul, however, dividend growth always means higher stock prices.

That’s why the return to dividend growth is such a positive factor for dividend-paying Canadian stocks. And it’s particularly favorable for the former income trusts, which had to put growth on hold for years due to concerns about post-conversion taxes.

At the beginning of the year I stated the return to dividend growth would be a major positive for Canadian stocks in 2011 and beyond, and was the single biggest potential catalyst to produce a “Hat Trick,” or a third consecutive year of outsized gains. That forecast has become somewhat problematic in light of the recent selloff.

But the return to dividend growth is probably the single biggest reason I expect all of these stocks to swiftly recover once investor perceptions of risk return to more normal levels. And given the conservative nature of these companies’ management, a dividend increase is the best possible assurance that the current payout is safe, regardless of how high the current yield goes.

Clearly, some companies’ dividend growth has been priced into their stocks. Portfolio picks Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPFF), Cineplex Inc (TSX: CGX, OTC: CPXGF) and Keyera Corp are good examples. So is Acadian Timber Corp (TSX: ADN, OTC: ACAZF), which is still up for the year despite a steep pullback since mid-summer due to worry about the impact on timber markets from global economic turmoil.

On the other hand, some dividend growers have gone in precisely the opposite direction. In the CE Portfolio, Ag Growth International Inc (TSX: AFN, OTC: AGGZF) provides the most stark example, as the stock has fallen nearly 40 percent on worries that global agricultural spending will fall, despite dividend and revenue growth to the contrary. Bird Construction Inc (TSX: BDT, OTC: BIRDF) has plunged nearly 30 percent since raising its dividend 10 percent on Mar. 4, 2011.

Davis + Henderson Income Corp (TSX: DH, OTC: DHIFF) increased its dividend 3.3 percent on Aug. 9, the first payout increase since the company converted from income trust to corporation and a clear affirmation of management’s intention to return to dividend growth. Yet its shares are off more than 10 percent since. Newalta Corp (TSX: NAL, OTC: NWLTF) is off 20 percent since May 9, when it boosted its payout 23 percent. And TransForce Inc (TSX: TFI, OTC: TFIFF) boosted its dividend 15 percent on May 17, only to see its stock fall more than 34 percent since.

A handful of resource stocks outside the CE Portfolio provide even more extreme examples. Teck Resources Ltd (TSX: TCK/B, NYSE: TCK) has raised its dividend 50 percent at the beginning of the year and its share price is down a like amount. Canadian Oil Sands Ltd (TSX: COS, OTC: COSWF) also boosted 50 percent, but its stock has fallen more than 20 percent. And uranium producer Cameco Corp (TSX: CCO, NYSE: CCJ) raised by 42.9 percent, only to see its stock crater more than 50 percent.

Eventually this dividend growth is going to drive share prices and produce strong capital gains. And in most cases it’s strongly backed by secure revenue, low payout ratios and low debt, which should ensure the increases hold even if credit conditions and the economy worsen.

Right now, however, dividend growth is having no real impact on how investors are pricing these stocks. Rather, the market action has everything to do with a rise in investor perception of risk, which varies widely from company to company.

There is at least one pattern in the data from the table. That is stocks in certain industries are definitely faring better than others. That much is also clear from the range of yields in the How They Rate table.

First, companies providing services or owning assets in an industry considered an essential service have generally fared well. Nine of the 10 Energy Infrastructure companies tracked in How They Rate have positive returns for 2011, even in US dollar terms. The only company to fail that standard is Westshore Terminals Investment Corp (TSX: WTE-U, OTC: WTSHF), which is still off only about 7 percent in US dollar terms. Eleven of 16 REITs are also in the black, and Electric Power companies on average are right around breakeven.

In stark contrast, I track 32 Oil and Gas Producers, and only Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF) and Progress Energy Resources Corp (TSX: PRQ, OTC: PRQNF) have positive returns for 2011. Every Energy Services company is underwater, as are 12 of the 14 Natural Resource companies tracked, eight of nine Transports and all four Health Care stocks.

Most sectors have at least one winner and one loser. But generally the takeaway is that sectors perceived to be less economically sensitive are being priced higher (and yields are lower) than sectors perceived more economically sensitive.

Broad themes like “all Canadian financials will fall if European banks fail” are getting attention and are what investors are acting on. Positive developments at individual companies, such as dividend increases or accretive acquisitions, are mostly ignored. And any increase in investor perception that a particular company’s dividend is at risk–including an expected drop in share price or rise in short selling–is greeted immediately with furious selling.

That’s not a very favorable near-term environment for anyone who believes, as I do, that real wealth is built by taking positions in healthy and growing companies. But it is clearly the nature of this market. And even the most dedicated long-term investor has to take notice.

What Works and What Won’t

If you get nothing else out of this article, let it be this: Selloffs based on investor perception will reverse with a vengeance when that perception changes.

Market sentiment today is still suffering from the aftermath of 2008. Despite stark differences between now and then, many still expect a repeat of that historic credit crunch/market crash/recession. And they’re frankly terrified of the prospect of being in stocks should that happen.

As I’ve pointed out time and again here, the real lesson of 2008-09 was once we were in the mess, buying and holding stocks of healthy and growing companies was the only way out. Strong companies did recover the pounding they took and then some. The only real losers were investors who lost heart and bailed and therefore failed to ride the recovery back to wholeness.

Even if this were a bear market of the magnitude of 2008, we’d already be about half way through it. Sure, it might have been nice to have some cash on the sidelines before this all began. But does it really make sense to run for the hills now, after so much damage has been done?

Moreover, there’s still plenty of reason to doubt this will wind up anything like 2008. For one thing, big bad and lasting bears almost never show when so many people are hunkered down and expecting the worst. One of the necessary conditions for a real panic is that enough investors are leaning the wrong way when the wall caves in.

Unless you count a few cranks, like me, I don’t see a lot of bullishness now. In fact, you could almost literally cut the bearish sentiment with a knife at the Toronto and Vancouver MoneyShows, where I spoke last month. Clearly, Canadians are expecting the worst, just as so many Americans are.

That doesn’t mean bad things can’t still happen. In fact, the European sovereign debt crisis is still far from settled and could well trigger tighter credit conditions on this side of the Atlantic, as so many fear.

The point, however, is if so many fear this, it’s already priced into the market. All 14 Financial Services companies tracked in How They Rate are underwater for the year, despite the fact that eight of them have raised their dividend at least once in 2011. Moreover, virtually all of them have reported strong earnings and have little debt risk.

That, to me, is pretty clear proof investors are pricing in banking industry adversity in Canada, if not a full-blown crisis. That’s a pretty low bar of expectations for an industry that by the numbers is in the pink of health. And given that perception, it’s going to take an awful lot of bad news for the industry to really disappoint anyone. Conversely, it won’t take a lot of good news to create a positive surprise that could radically move investor perception to the positive.

The same is true across the market. Falling oil and natural gas prices were the obvious catalyst for the drop in Canadian energy producer stocks since summer. The stocks, however, have fallen much more sharply than the commodities, even companies like ARC Resources Ltd (TSX: ARX, OTC: AETUF) that have shown their ability to grow profit by expanding output.

What happens if energy prices start heading higher again, defying the extremely low bar of expectations built into these stocks? That depends on how high oil and gas go. But clearly, it’s going to be a very nice time to be holding these companies.

Timing is a question mark. And if there is another high-profile dividend cut in Canada–as Yellow Media’s was–or if the banking crisis breaks loose for real, recovery will no doubt be delayed and panic will offset bargain-hunting for a time. But the message is clear and it’s the same one I’ve had for some months: As long as your companies stay healthy and growing, don’t be deterred by macro babble. Stick with them.

Of course, there are companies in the How They Rate coverage universe that are very much at risk now, even if conditions don’t noticeably worsen. One group are the companies highlighted in Dividend Watch List, a must-read this month.

Infinitely more at risk, however, are the eight companies listed in my table “Possible Margin Calls.” The two greatest risks for dividends now are inadequate revenue and too much debt. For these companies, however, they’re also risks to solvency. 

Each of the companies in this table faces a threat to revenue in coming months, particularly if the North American economy weakens again. For Advantage Oil & Gas Ltd (TSX: AAV, NYSE: AAV) and Perpetual Energy, it’s the continuing plunge in natural gas prices. That, ironically, makes them the best candidates to escape a squeeze, as management does have tools to deal with weak pricing.

Meanwhile, HOMEQ Corp (TSX: HEQ, OTC: HEITF) actually saw the opposite of revenue weakness in the first half of 2011, as it signed on a record number of reverse mortgages.

The rest of these companies are coming up against it. That includes Equal Energy Ltd (TSX: EQU, NYSE: EQU), a small oil producer that’s likely to be hit by the summer dip in black gold even as costs are rising. Cinram International Income Fund (TSX: CRW-U, OTC: CRWFF) is still reeling after losing its major customer this year. Lanesborough REIT’s (TSX: LRT-U, LRTEF) properties in Fort McMurray, Alberta, are still distressed, despite that area’s ongoing recovery. And Norbord Inc (TSX: NBD, OTC: NBRXF) is a construction materials company that clearly can’t take much more US housing market weakness.

The greater risk to all of these companies, however, is near-term debt maturities that–after the recent stock market selloff–are now a formidable percentage of market capitalization. That will make it very difficult to pay them off with equity or cash flow. And if credit conditions tighten meaningfully, they could all face a giant margin call as Yellow Media did, as lenders call in cash to reduce their exposure to a total company meltdown.

Advantage’s obligations are CAD62 million in convertible bonds that mature in December 2011. Despite the drop in Advantage shares, much of these issues could well be converted into stock, rather than paid off in cash. More dangerous are credit lines due in 2012, which banks could well get nervous about if gas prices fall further. That’s what happened in early 2009 and it nearly wiped out shareholder value.

My view is this company survives. But until gas prices stabilize, only very aggressive investors should hang on. That’s also my view for Aggressive Holding Perpetual Energy, which is reviewed in Portfolio Update.

I have no such assurance, however, about the rest of these companies. Imvescor Restaurant Group Inc (TSX: IRG, OTC: IRGIF) management again admitted last month that it has not been able to reach a settlement with owners of its 7.75 percent convertible note that mature Dec. 31, 2011. That’s a sum it’s clearly unable to pay, and the likely result will be a total shareholder wipeout.

That also appears to be where Lanesborough REIT is headed as well, with a CAD26 million note due Dec. 31, 2011, that it has no visible means of paying off. Cinram, meanwhile, has CAD90 million due Dec. 31, 2011, for which it’s engaged a financial advisor to pursue “strategic options.”

The risk in these companies hasn’t been lost on the market. In fact, all of them have dropped considerably this year, including those that had already fallen sharply previously. These losses will no doubt lead some investors who still own them to conclude they’re better off hanging on for a miracle. Certainly, I’ve heard that sentiment fielding questions from readers who still own Yellow Media, after that company’s latest plunge.

My answer is simply that it’s better to get out some money from a blowup than none at all. Sure, the amount may not be significant and selling means admitting defeat, which is never pleasant. But any money salvaged can be redeployed into something that is paying dividends. That makes a lot more sense than leaving funds in a stock that is most likely headed for zero, and pays nothing while you wait for its ultimate demise.

There’s also the matter of how to take a loss on a stock that no longer has a price. That’s the reality for anyone who hung on to Priszm Income Fund hoping for a miracle. The stock has now been de-listed from the Toronto Stock Exchange. Even Bloomberg won’t give a valid price. Investors can attach a zero to the price when filing taxes, but it won’t be nearly as clean as simply taking the loss while there was still trading in the stock.

The good news is stocks like these are a tiny minority in the Canadian Edge coverage universe of dividend-paying stocks. Even in 2008, most stocks held their dividends and therefore recovered capital losses, once investor perception of their risk lessened. This time will be no different, other than 2011 isn’t yet nearly as severe an environment as 2008 was and therefore the recovery might come even faster.

What should you buy? The best choices are stocks that you’ve vetted fully already. There’s no such thing as perfect knowledge in the stock market. But getting as up to date as possible on the risks of individual stocks is the next best thing and will keep you away from most problem situations.

Portfolio Update looks at all of the Aggressive and Conservative Holdings under the CE Safety Rating System, which I’ve toughened up to provide a better gauge of risk should economic and credit market conditions really deteriorate in coming months. Ratings for other stocks are shown in How They Rate.

The companies that come in with 5 and 6 ratings aren’t foolproof. And it’s possible they’ll stumble at some point. But as of right now and using all available information, they’re in the pink of health. That includes several that yield well over 10 percent, due to what I believe to be an over done investor perception of dividend risk.

Owning a basket of these stocks is the least risk way to position for the recovery, the chief catalyst for which will be the lessening of investor risk perception. Diversification ensures a problem at one won’t sink your entire portfolio.

Meanwhile, you’ll still be in the game for what may now be a difficult hat trick for the Canadian market but will surely be a robust recovery in the coming months.