Last week I introduced a social cycle phenomenon that I term the Saeculum defining a period roughly equal to a human lifetime. Within this cycle, public confidence rode high as evident by the “buy and hold” mentality gripping investors. Regardless of market dips and swoons, investors were always encouraged to use those periods to “dollar cost average” their stock purchases. The idea of stock liquidation and taking a loss never gained traction in the public’s mind. This single-minded belief in perpetually rising stocks is a component of the public confidence of the period.
This article introduces another measure of public confidence called the dividend yield. The material for this article is derived from a stock market forecast from February of this year along with recently updated data. The average dividend yield of the stock market, using the Dow Jones Industrial Average, is the sum of the dividends paid by the companies in the Average divided by the sum of the stock prices for the same companies. Companies pay dividends to the shareholders as a way of distributing the earnings. When the public buys a stock, the expectation is for there to be dividends, for the stock to increase in price, or both. The dividend is a “reward” for the stockholder for partial ownership of the company. An investor who buys stock wants to see a return for their investment. The dividend is the return for buying and holding the stock.
During times of extreme confidence, the public is mostly interested in seeing their stock price increase and the dividend is less important. Confidence extreme was evident in 2000 when the dividend yield was barely over 1%. A one percent (1%) dividend yield implies that owners of stock were content with being paid 1% on their money. Compare the 1% rate with rates offered through banks and money market mutual funds during the same period. It even became a badge of honor for some companies not to pay a dividend yield.
During times of diminished confidence, an investor demands a high return on their money since the interest in owning stocks has lessened. Investors in bear markets have far less interest in owning stock when they have taken a beating on their stock ownership. The loss of confidence due to falling stock prices makes stock ownership a more risky proposition implying the need to compensate investors for the increased risk. The increase in dividends provides some of that compensation.
In two of the most recent bear market bottoms (1974 and 1982), the dividend yield was between 6% and 7%. At the bottom of the 1932 bear market, the yield was near 14%. The dividend yield for my stock market forecast on 2/9/2009 was 3.86%. When there is fear in the market, an investor expects a higher return for the potential risk of seeing their stock investment decline in value. A rough example would be extending a loan to someone who you feared might not be able to repay the loan in full. For this loan, you demand a higher interest rate to compensate for the perceived risk.
To reach the dividend yield of the bottoms of 1974 and 1982, the following is necessary:
a) Dividends would have to nearly double with the stock prices staying the same
b) Dividends would remain the same with the stock prices falling by 50%.
Case a)
Increases in company dividends in the current deflationary environment are unlikely. A dividend is a reflection of earnings not retained by the company (shareholders receive dividends). When companies lose money, dividends may not be paid. This negates case a).
Case b)
This case is more plausible since dividends are not likely to increase and could in fact fall.
The analysis considers the bottoms of 1974 and 1982. Our supposition is of a bear market of multi-generational dimensions. If so, the dividend yield of 1932 (14%) is a better target for a bear market bottom. Using a 14% dividend yield as a target implies a fall in stock prices by a more significant amount than we have seen.
Based on dividend yield, we are not close to a market bottom equivalent to 1974 or 1982. Moreover, we are quite distant from a bottom such as 1932.
I now present fresher data and a different perspective on dividend yield. As of July 31, the average dividend yield of the S&P 500 was 1.96%. While this figure is low, and roughly 2% LOWER than in February, consider that 139 stocks (nearly 28%) in the index paid NO dividends, meaning their dividend yield is ZERO. Another 65 have a dividend yield of less than 1%. So roughly 40% of the S&P 500 pays has a dividend yield of between 0 and 1%. Clearly, there is not broad health to support a bull market if the ability of companies to pay a dividend is the criterion. At the bottom of the bear market, investors will once again demand a healthy dividend yield since it will not be simply enough to own a stock for the anticipation of a capital gain. A dividend yield of 1.96% is more reminiscent of a market top than a bottom.
If 40% of S&P companies have such a small dividend yield then the remaining 60% must buoy the indicator to a large degree. Can those 60% continue to provide the floatation device for the rest? The July issue of the Elliott Wave Theorist provides a clear answer to this question. In this issue, they cited Ian McAvity, publisher of Deliberations on World Markets, a technical newsletter covering precious metals, currencies and global equity markets. Ian has published his letter for 36 years. He conceived a ratio called the S&P 500 payout ratio. The ratio tracks dividends as a percent of earnings for the stocks comprising the index (Dividends/Earnings).
As of mid-May 2009, the ratio stood at 317%. What does this mean? In order to pay a dividend, a company should have earnings. The dividend is the reward for the stockholder (their “income”). The pool of funds from which to pay these dividends are typically earnings. While a company could pay dividends from other sources (cash held, selling of assets, etc), this would not be a sustainable path. A company could decide to pay 100% of its earnings in the form of dividends but then nothing remains for anything else. Historically, companies paid an average of 50% (this is a very rough estimate) of their earnings as dividends. As recently as December 2006, the figure was 32%. We have never witnessed a figure above perhaps 80% in the history of the data going back to the 1930s. A figure of 317% is not sustainable which means one of two things must happen:
a) Earnings must TRIPLE just to bring the index below 100%
b) Dividends will be slashed dramatically
Since it is fair to conclude earnings will not triple in the current economic climate, dividends will be slashed dramatically for those 60% of companies with dividend yields above 1%. When companies slash those dividends, the overall dividend yield of the S&P 500 index will plumb depths even lower than those witnessed in our recent stock market tops. Since low dividend yields are indicative of tops as opposed to bottoms, the 317% dividends/earning ratio is among the most alarming statistics of this bear market rally!
Despite a dramatic fall in stock prices, albeit with a multi-month recovery, investors continue to demonstrate the confidence of the previous Saeculum. Using the dividend yield as a measure of the public’s investing confidence, it is clear the market has not made a significant bottom and in many respects signals a top. The ultimate fall of the stock market will shatter public confidence in a manner not seen in generations.