The ‘Efficient Market Hypothesis’ asserts that financial markets are ‘informationally efficient’. Thus the price is always right. The Dividend Discount Model suggests that this has been the case only 83% of the time over the past 30 odd years. The conclusion is that since March 2009 we have had, and still have, one of the greatest buying opportunities of all time resulting from:”Irrational Pessimism,“ spawned of FEAR that has yet to dissipate.
Value and price are not always the same as shown in the first chart below. Between 1981 and 1995 they were 96% of the time. In the latter half of the 1990s the price of the DJII exceeded its value during Alan Greenspan’s period of “Irrational Exuberance” where greed ruled supreme and ended with era of the Dot Bombs.
During that time, however, the value of the DJII kept rising and lent solid support to the price of the DJII by the early years of the millennium and through 2008. The financial collapse following the Lehman catastrophe brought the price of the DJII down to a level considerably below its value as “Irrational Pessimism” took over fueled by FEAR. Despite continuing pessimism the DJII price has been grinding higher and is already up 123% from the 2009 trough. The Value of the DJII stands at 27,447 today while the price continues to move slowly back to value.
While the first chart tells the story of the relationship between price and value the question remains:
“What is the determinant of Value?”
Starting from the premise that investment is a long-term proposition and that the performance of one investment is always relative to a riskless return the best way to measure this is using the Dividend Discount Model.
Common equities are irredeemable instruments. Hence, the only return on investment that a shareholder receives from a company is a dividend. Capital gains and losses come from the market and these are driven by either actual or anticipated growth in dividends and changes in interest rates. As equities are perpetual they should be measured against the long end of the bond market. In the extreme the British Consols and the like, but in practise the 30 Year T Bond yield provides an excellent proxy.
Think of equities as perpetual bonds with variable coupons, the coupons being dividends that by-and-large rise over time. Dividends are more robust than earnings which can be extremely volatile as noted particularly in the immediate aftermath of Lehman
Dividends by comparison have been much more stable.
Price and Value
The Yield (or interest rate) on a bond = Coupon/Price or i =C/P
The price of the bond can thus be calculated as P=C/i. As the coupon is fixed any increases in interest rates i, would result in a falling bond price to bring it in line with similar but newer bonds. The converse is also true.
Replacing the Coupon with a Dividend would result in a fair Price (or Value) of an equity relative to a 30 year T bond V=D/i .
Again, as long interest rates rise the value will fall. However, if the dividend rises it could well neutralize the negative impact of rising interest rates. Should interest rates fall the value would rise in tandem with the bond market but if the dividend also rises the positive impact on value would be compounded, as was the case between 1981 and 2008.
In essence, changes in value are a direct function of dividends and an inverse function of interest rates:
Since the nadir of the bond market on September 29, 1981, it has risen 4.92 times as the yield (or interest rate) on the 30 Yr T Bond has fallen from 15.2% to 3.09%. In line with this we would expect equities to have risen by the same amount. However, the DJII dividends have also risen by 6.38 times from $55.79 to $355.90. The product of the 4.84 multiple expansion, from the drop in the interest rate and the 6.38 fold increase in the dividend should result in a 31.40 fold increase in the value of the DJII and with at least an 83% probability the price of the DJII should also increase by the same amount.
In the event the price of the DJII has not moved up as much as value but it certainly seems to be ratcheting slowly upwards as pessimism dissipates. This is despite the talking heads of the media having no clue as to why the market is rising or how far it might continue. Certainly they know the price of everything but unfortunately not the value. They are confused, to say the least, by the rise in the market when the Roubini-esque economic commentators are still predicting we are about to fall into an abyss just around the corner, as they have all the way up since March 2009.
Believed to be from the New Yorker Magazine, and judging from the shape of the TV and the rabbit ears, it appears to have been published circa 1960.
Dividends have been more robust than earnings as corporate directors are reluctant to cut dividends in line with falling earnings. Cuts or the elimination of dividends are viewed negatively by many institutional investors. Some pension funds and insurance companies have to sell positions in the case of dividend cuts or eliminations. Hence, when earnings fall in recessions the payout ratio moves up and even to infinity immediately following the collapse of Lehman.
The payout ratio at 39% today is near a record low level, despite many corporations being flush with cash. As confidence returns to corporate board rooms, and FED permission is granted to banks, the payout ratio could well be increased as early as this year.
Inserting here such a possibility as the only forecast in this paper, it is conceivable to see a 4.5% rise in nominal GDP in 2013 which should be sufficient to result in the DJII earnings (which are also nominal) rising by 10% to $1,000. Simultaneously, the payout ratio could rise to say 50%, (the average over the past 30 odd years has been 63% but that has included those years where the earnings have fallen precipitously).
A 50% payout would see the DJII dividends rising 40% from $355.90 to $500. With no change in interest rates this would push the value of the DJII to 38,500. To bring the value back down to the current price of 14,579 the yield on the 30 yr T Bond would have to rise to 8.2%. It seems unlikely that the FED will let that happen. However, if it does the economy and inflation would be probably expand much more than expected and so too would be earnings and dividends. Whichever scenario transpires it is highly probable that the upward pressure on the price of the DJII form the current level of 14,579 will continue with ever-increasing momentum.
The next chart demonstrates how both the bond yield and the equity yields have fallen over time and since Lehman the DJII equity yield has on occasion above that of the T Bond Yield.
Furthermore, the ratio of the DJII yield to the T Bond Yield has been well in excess of the historical average of 42%. A return to which level based on current interest rates and dividends would require an 88% increase in the DJII to 27,440.
What a Surprise! This is the very same value level shown in the very first chart but this time on a log scale.
This is followed by an arithmetic scaled version with a shorter time frame.
What about using earnings and P/E multiples?
Many commentators concentrate on earnings and P/E multiples but as shown previously, earnings have been extremely volatile during recessions as shown again on the next chart.
The P/E multiple has been even more volatile yo-yoing as shown below. Using an average P/E multiple in isolation, as a determinant of value is of little use, for it fails to consider the returns available from alternative investments. In the following chart this is shown as the yield on the 30 year T Bond.
The FED model suggests that the earnings yield (the reciprocal of the P/E multiple) should equal the long bond yield. However, with the volatility of earnings over time the fit is not the best. Despite this it is important to note that before Lehman the earnings yield was rarely in excess of the long-bond yield to the extent that it is today.
Assuming that the earnings yield returns to parity with the long bond yield then either interest rates have to rise or earnings drop or, as appears to be happening, the price of the DJII has to rise to 29,000. While this is higher than the value indicated by the dividend discount model it should be remembered that the dividend payout ratio is near a record low. Even so the rise in the price of the DJII to match the FED value is a similar order of magnitude to that using the Dividend Discount approach.
Data Sources: US Federal Reserve, Dow Jones
Anthony G. B. Hayes BSc. (Hons) DIA, CFA
Tel: 905 468 0130
April 1, 2013