It’s days like Monday and Tuesday that have investors reconsidering their portfolio…and maybe their life in general. The Dow Jones Industrial Average (DJIA) dropped 793 points to end the day Tuesday at 15,666 – down over 5%. The S&P500 dropped 98 points points to end the day Tuesday at 1,868 – down almost 5%. And the NASDAQ dropped 200 points to end the two-day period at 4,506 – down over 4%.
Theories as to the reason for the unusually large decline vary wildly depending on which talking head you happen to tune into on your various financial news networks. Listen long enough and you’ll most certainly hear one of the following popular talking points: China’s economic cool-down and the rippling effect it will have throughout Europe, Asia and eventually the West; speculation over the U.S. Federal Reserve’s policies and success or failure of quantitative easing; Chinese interest rate cuts and the potential deflationary influence that might have on the global economy; or even, continued weakness in the euro-zone and the Greek bailout that dominated the news cycle just a few weeks ago.
Reader: Great, but what does this have to do with dividends?
Author: Bear with me.
Any of the aforementioned reasons could have contributed to the significant market drop earlier this week but I prefer a simpler explanation – the U.S. markets were highly overpriced and needed a trigger for a correction. Consider that since the absolute low of the 2008-2009 recession to the absolute highs of 2015 that the DJIA, the S&P500 and the NASDAQ indices have grown roughly 127%, 184%, and 272% respectively. Growth in and of itself does not mean “overpriced” per se – after all, markets are supposed to grow or else why would we invest in them. But investors, especially causal investors, often forget the cardinal rule of economic cycles (and Sir Isaac Newton’s favorite saying) “that which goes up, must come down”. After almost 7 years of continual growth perhaps we were (and perhaps still are) due for a correction.
What is a good measure of a market’s worth? How can you tell if it’s time to buy or time to wait for the correction? It’s a topic much written about and worthy of its own article, but for the sake of brevity let’s look at two measures. Historical price-to-earnings ratios and my personal favorite measure, the Warren Buffett Indicator.
Reader: I thought this was an article about dividends???
Author: It is, I promise.
The price-to-earnings ratio, as the name implies, divides the price of a company’s stock by the earnings per share of that same company. Another way to think of it is, “How much money am I willing to pay for every $1 worth of annual earnings that a company produces?”. The higher the P/E ratio, the more I’m willing to pay for a dollar of earnings. This is often seen as a measure of confidence that a company has a lot of upside and will continue to grow. The lower the P/E ratio, the less I’m willing to pay per dollar of earnings. This can be interpreted as a lack of confidence in the company’s future. It’s also a fantastic way of comparing the stock price of two different companies since looking strictly at their raw stock price doesn’t make sense due to differences in the total number of shares outstanding and a variety of other factors.
A simple way of evaluating the market as a whole is to compare the market’s current P/E ratio to its historical P/E ratio. Essentially this is adding up the price of all stocks for a particular index and dividing that by the earnings-per-share of all the companies in that same index. As you’ll notice below based on the http://www.multpl.com/ site that tracks just such an index, the S&P500 has been at a relatively high P/E for quite some time. Not 2008-2009 recession high, not tech-bubble high, but still higher than almost all of the decades between 1920 and 1990 including the Great Crash of 1929. That’s pretty darn high.
P/E Ratio for Trailing Twelve Month (TTM) Earnings
Now let’s talk about the Warren Buffett Indicator (WBI). The WBI, much like the aggregated P/E ratio attempts to estimate how fairly valued the stock market is. But unlike the P/E ratio, the WBI takes a much more macro-economic approach by comparing the total market capitalization of all stocks in a country to the total economic output of that same country (Gross Domestic Product GDP). In layman’s terms the WBI = (all shares of stock in a country times the current share price of those shares) divided by (the value of all services and products produced by a country). It’s essentially like a P/E ratio on steroids.
Reader: I was told there would be dividends!!!!
Author: So close, bear with me!
The website www.gurufocus.com does a fantastic job of tracking this and other similar ratios like the one displayed below on their site. In addition, they take things one step further and even attempt to predict how much of a return the stock market is likely to yield (based on historical data) given the current valuation. What’s their current estimate for stock market returns over the next year? You guessed it… very bad. Given the current market cap to GDP ratio the stock market is likely to return 1.2% over the next year. *sound of weak applause*
As you can see based on the graph below, the WBI is also close to historical highs. Like the P/E ratio analysis we are still not at tech-bubble highs yet, but unlike the P/E analysis the WBI evaluates the current market higher (ie more expensive) than even the 2008-2009 recession market. This is also not good news.
The Ratio of U.S Total Market Capitalization to Gross Domestic Product
Suffice it say based on just two measures, the U.S. stock markets as a whole seem expensive and possibly significantly overpriced. Many other indicators that we didn’t cover would also support this claim. What happens to overpriced markets?
Option 1: They correct (…crash)
Option 2: They bounce around wildly until growth/earnings catch up to the price OR…
Option 3: They revisit Option 1 (…crash)
In either scenario, profiting from stock appreciation is incredibly difficult for the average investor – unless you fancy yourself an experienced day trader which I would not recommend. Individuals have historically turned to safer more secure investments in times like this, like bonds and government treasuries but as I’m sure you already know… interest rates are incredibly low. Like super super low. Like, my savings account interest rate has more zeros after the decimal than the number of people that made it this far in the article. *sound of one guy clapping*
Reader: That’s it. I came for dividends and…
Author: AND HERE’S WHERE DIVIDENDS COME INTO THE PICTURE!
Dividends are a perk of stock ownership with many companies. When a profitable company thinks a little extra cash would look better in their shareholders’ pockets rather than reinvested in the business, they can issue a dividend. This payout sometimes happens quarterly, sometimes annually and sometimes as a one-off event. However, many companies have offered consistent dividend payouts for years if not decades. And many companies have steadily increased their payouts over that same time period.
Dividend yielding stocks are not without risk. Like any other stock, dividend yielding stocks can dramatically drop in value. Dividends can be suspended, decreased or cancelled altogether based on the financial wellness of the company. Dividend yielding companies can even go out of business. In times when interest rates are high and U.S. Treasury yields (arguably the safest investment known to man) creep up into the 5-10% range as they were for most of the 80’s and 90’s, then dividend yielding stocks, and the stock market in general, become far less attractive. In our current financial environment where yields on debt based securities are almost non-existent, dividend yielding stocks almost become a no-brainer.
Another added perk to dividend-yielding stocks in a bearish market is the dividend yield calculation. If I buy one share of Apple Inc. (APPL) for $100 and APPL issues a $2 dividend annually, then I’ve just made 2% on my investment assuming the stock price doesn’t change. Sure beats the pants of my savings account interest rate analogy. Here’s the best part: Let’s say I waited another week to buy that same Apple Inc. share because I thought the stock market was overvalued. A week later I buy that same share for $80 after the market corrected, but because Apple’s long term business did not change as a whole, and because they have plenty of cash laying around they still issue their $2 annual dividend. Now my $80 investment netted me a return of 2.5%!
This is an oversimplification of course but my point is this, market corrections and bear markets as a whole cause stock price depreciation, which in turn raises the dividend yield calculation. The lower the market goes, the better those dividends start to look. Again this is assuming the company is stable enough to continue issuing a dividend and that the company’s stock price doesn’t depreciate much faster than the market as a whole.
Reader: You should have just led with that section
Author: The background is important…jerk.
Assuming you’ve bought into this line of reasoning and assuming you are still awake you might be wondering how to go about picking quality companies that offer a solid dividend return. How do I know what stocks offer the best yield? How do I know which stocks have the most consistent dividend? How do I know which stocks have experienced the best dividend growth? How do I know which stocks are least likely to wildly fluctuate in price?
In my next article I will provide in-depth analysis on this very topic and provide some useful strategies and picks for selecting the best dividend yielding stocks based on your specific financial goals.
Tune in very soon!