Tuesday, August 28, 2007

Did Someone Say Molehill?

We've got two awesome graphs down below...

The top is the real price of the S&P 500 (adjusted for inflation) from 1947 to the first quarter of 2007. The second graph is the year to year dividend payout by firms in the S&P for the same time period - I lined up the inner graphs for easier visual comparison.

All of the S&P data come from Robert Shiller's (at Yale) data archive, which is one of the greatest things ever.

What's nifty about the two charts in tandem is that they show S&P firms' responses to their changes in their stock prices (and the rest of the environment, of course). For example, at the end of 1987 stocks took a dive, and companies pumped up their dividend payments to shareholders more than a full percentage point (from 2.61% at the end of August to 3.66%).

Notice that nowadays we've got an incredibly low dividend rate from the S&P. This is partly because, presumably, a high dividend rate is necessary to attract investors to a stock. Since we've had phenomenal returns over the past 13 years or so (less a few bad years...), the dividend hasn't been as important.

However, can we interpret a below-average dividend rate as a consequence of above-average growth in our economy and S&P companies? If so, we could assume that the "distance" from the mean to which S&P companies' growth will ultimately revert is given to us (in some part, at least) by the distance from the mean in dividends.

So, how much downside potential is there in growth's reversion to the mean? Realistically, companies have about 1 full percentage point of dividend rate "leeway," before they are at normal (historical) levels. If we have any faith in the public (or the market's) ability to determine their own risk levels, we could conclude that people are overly confident (compared to historical averages.)

Essentially, I'm suggesting that the stock market should, at some point, get a jolt of "under confidence," and we'll see the dividend rates pop up just like they did in 1987, around 1990 and around 2002. The difference now, though, is that dividend rates have a lot further to go before they get to normal levels, suggesting that any fear-driven swing to lower investor confidence will cause greater than average drops in stock prices, as the solid investors (dividend-hungry, long term holders of stocks) are clearly not as prevalent.

This seems a little unprecedented to me - since there have always been relatively high dividends to appease the core, long-term investors, any downturns in prices were supported at a certain point. With a base that seems to enjoy a 1% return, though, we can assume that the majority of the money in the stock market is chasing growth. So, the day that growth starts reverting to the mean, we'll see a far greater-than-average reversion of stock prices.

This has already been shown to be the case, by the way, in the drop of 2000 - 2003. If you compare a graph of real GDP with stock prices, you'll see a HUGE percentage drop in stocks coupled with an INCREASE (although not as big as previous years) in GDP. (I'll bring these graphs to show and tell some day...) This means that it is not an actual recession that causes massive panic and stock losses, but rather the prospect of a lower, but still positive, rate of return (growth.)

This is pretty obvious, of course, but it is striking - to me - how the transition from 0.8% (Real) GDP growth in 2001 to 1.6% (Real) growth in 2002 occurred alongside a 22% drop in the S&P from January 2002 to January 2003. The striking part is that fear of tepid growth (and some other stuff I'll get to in a bit) is what caused the fall, rather than recession, real declining growth or anything else we normally assume causes stock declines.

While this is expected by people who know what they're doing, it's the underlying implications that matter now, especially to those of us who would like to know: If we have evidence of over-confidence coupled with the lack of a solid investor base, then any stir in the future growth prospects of stocks (specifically a slowing GDP growth) will cause, again, gargantuan stock declines EVEN THOUGH S&P PE ratios are only about 25% above historically "safe" levels.

Here, have a picture:

So we might be overpriced by 20%+, or maybe not, considering the U.S.'s connectivity with global growth. The point is that it doesn't matter. At some point, fear of reduced U.S. growth is going to cause us to start underpricing, at least down to PE levels we saw in 2003. This is exactly why the so-called subprime "crisis" was a "crisis." Because it caused - I hate to say it - "Big Money" to start forecasting lower growth rates, and subsequently start buttpiling into treasurys and safer investments.

(I'm annoyed that the spell check on this thing is asking me to fix "treasurys." ...And "buttpiling"...)

Normally, this fear of reduced growth would involve the shorter term, high-yield guys to exit and leave the long term, high-dividend guys supporting rational PEs. For the past few years, those long term guys are not being paid enough to purchase U.S. stocks (i.e. dividends.) and thus they have either more foreign-dividends-at-some-small-risk investments, or simply have greedily transformed their investing mantras into growth chasing.

So, when real fear - based on accurate signals of slowing U.S. GDP growth - hits the U.S. stock market, we're going to see a similar decline to that of 2000-2003, due to the growth chasers exiting first, the FED beginning a "signaling era" of reducing the funds rate, followed by a protracted era of low confidence in equities (which is made worse by the federal reserve signaling the necessity of lower rates.) This should, in my nutcake opinion, last until both the fed and the public move together in determining "the bottom," just like they did in 2003. After that, we'll have even faster - but more rational - reversion to the mean, based on more modest confidence and honest forecasts of proper P/E ratios and U.S. and global growth.

That is, of course, until we overshoot the mean, then the whole thing will have to happen again, but at higher price levels... Just like it always does...

Also, I've got at least three other arguments for why we should be expecting a pretty large decline in stocks over the coming years, so if I seem to be overemphasizing this one particular point, it's because my biases are bleeding through. So I apologize for all the fear-mongering, but hey - I think a little negativity is a good thing when most people are so optimistic. Even if I turn out to be completely wrong, at least I can say I did my part in trying to add cautious moderation to all the wild growth, right?


Fred said...

With the "Dividend rate Pop" being so continual, I am not sure that I would say that the market will make a huge decline - I will take a relational (possibly irrational) look at extremes...yours being on the 'negative' side.

When the great depression hit (largest decline ever), the market wasn't nearly as complicated as it is now...not as many public markets, stocks, bonds, mutual funds, annuities, etc...not to mention private stock as well! The diversity of the market allows the security for a naive POSITIVE outlook that there is nothing to fear. Largely because the machine is too big.

I can sum it up in a simple simile/metaphor (what is a meta-phor? (Laughing out Loud!)) -

It's like a sheet of aluminum foil - when it's spread thin, it's weak. A single dent hurts it a lot. But when you dent it enough, it turns into a ball that is strong enough to throw, impale, roll, bounce, mold, and even take more small dents - but the strength can't be taken away...without being spread thin again.

It seems to me that you look at it like this:

It's just like why people drive SUV's - it's a big machine, they have a false illusion that even if it gets dented, nothing won't ever be bad enough to hurt them...-

My open ended, and assumingly, broad point is this - the market is so diverse and large, that the dividends making a dent, isn't going to affect the market as a whole, tomorrow there will be a dent somewhere else and dividends will rise again, fall again, rise again, etc.

Unless companies stop going public, you aren't going to unwrap the ball that IS the market, nor can you spread the market thin while the 'savvy' investor realizes that money isn't real, that it's just a concept. Sorry for the tangent, but as long as the human can imagine that the value of a piece of paper has worth - then companies will continue to go public, "dividents" will continue.

(My apologies to the readers - I tend to think in pictures, so metaphors and similes are often my best form of communicating at times...Oh, and Foreecon - I know, I know, there is no such word as assumingly nor dividents!)

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