Trader’s Narrative

Last Friday we looked at the unprecedented earnings collapse that has fueled this bear market. The chart below is the flip side, showing the impact on the S&P 500’s valuation through the Price/Earnings ratio:

Source: Chart of the Day

While the P/E ratio is a familiar rule of thumb that helps us to calculate the relative value of the stock market, like any metric it has a handicap. Looking at the chart, it is clear what that is for the PE ratio. Just imagine how ridiculously meaningless the ratio would be if we actually see negative earnings as many are predicting we will, for the first time ever!

But there’s no reason to panic, running out into the street screaming at the top of your lungs. The fact that the S&P 500’s price earnings ratio is 122.45 right now, once again proves that the price dividend ratio is a superior measure to price earnings. Dividends are a much better way of measuring value because unlike earnings, they are not prone to creative accounting and are considered sacrosanct.

While the P/E ratio is finding irrelevance in the stratosphere, the price dividend ratio is 38.6 - click previous link to see a historical chart of the price dividend ratio. And click this following link to see a chart of the price earnings ratio before the silliness began.

As S&P 500 earnings have collapsed from $62.28 - a year ago - to the present’s miserly $7.21, dividends have been much more robust. Dividends were $28.93 in May 2008 and currently they are $22.87 - a fall of just 21%. The Dow Jones Industrial dividend has fallen even less, 3.6%.

In the end, this is why we use many different methods to measure and analyse the market. Sooner or later, any one of them will go bonkers and provide useless output. At that point, it is important to realize that and not follow it over the ledge like lemmings.

First the bad news: earnings are horrible. Downright depressing actually. As the chart below illustrates, we’ve seen nothing short of an utter collapse during the most recent bear market:

Clearly what we’re going through is not your average, plain-vanilla recession. That would be the blue dashed line above. Even the last recession which came about as a result of the popping of a massive speculative bubble in technology shares and topped off by the economic body-blow from the September 11th attacks pale in comparison. What we’re seeing is the single most severe drop-off in earnings on the record.

Now for the good news. It may not matter at all - that is, when it comes to the stock market. Of course, to the economy, the employees and companies involved there is a significant consequence and I don’t mean to trivialize it. But the stock market is not the economy. For an example of what I mean, consider the company that started the most recent earnings season.

Alcoa (AA) released their earnings report after market close on Tuesday. They reported a loss of about half a billion for the first quarter. As you might expect, at first its stock price fell in after-hours trading but it closed higher the next day (Wednesday shown by green arrow) and today it gapped up and closed almost 10% higher:

Is this normal? Yes, of course. In contrast to what you may have heard, stock prices are not driven by earnings. This is one of the key characteristics of the stock market that throws a lot of novices because it just doesn’t make sense. But it does, once you realize that prices are set by a number of factors and while earnings are certainly part of the recipe, they are not the dominant ingredient.

If you look at enough charts you’ll see stock prices that are falling for companies that are reporting increased earnings and also stock prices that rise with decreased earnings. The key isn’t earnings, which after all, can be heavily manipulated unlike dividends. But rather the meaning that investors attribute to them. In other words, the price-earnings ratio. And that, is all about “animal spirits” or sentiment.

In Why The Price Dividend Ratio Is Better Than PE Ratio I argued that the lesser ratio based on dividends offers more insight. Here’s a follow up with an interactive long term chart.

It contains a massive amount of information so it can take a while to load… be patient, it is worth it. Not only does it show the historic ratio, it is interactive so you can zoom in on a shorter time frame by using the slider at the bottom:

The data is from 1871 to June 2008. To bring it up to date, the most recent data for the S&P 500 Index (SPX) gives a P/D ratio of just under 32. A year ago it was at 54. The last time we saw a price dividend ratio of 32 was in 1991. To put the current 3.13% dividend yield into perspective, in June 1932 stocks were yielding on average 14% and in July 1982, stocks yielded 6%.

Right now the Dow Jones price dividend ratio is 25.7 which is very close to the long term average. But the ratio can over shoot on the downside. By the way, I’m still looking for similar historical data for the Dow Jones, so if you have a lead, let me know.

And keep in mind that both the numerator and denominator are constantly changing, so this is a fluid number. Although we’ve seen prices fall dramatically these past few weeks, dividends can also fall. So the good news is that this ratio has fallen a lot but the bad news is that it can continue to fall as dividends are cut or reduced.

On the plus side, an important variable that can act as an emergency break on this ratio is the interest rate. If the Fed takes rates down to 1% or less, which some believe is a matter of when not if, then dividends will be much more attractive, relative to the alternatives in the bond market.

Already if you look around you’ll find quite a few high yielding household names like Pfizer (PFE) which is now yielding 7.7%. Looking back almost 30 years (I got tired of looking back more) Pfizer has never skipped or lowered a dividend payment but has consistently raised it.

Unless Bernanke takes interest rates down to zero, what we could be facing is a return of this ratio to the “normal” range it has occupied for most of its history. That is somewhere between 12 and 35. Under this scenario, the stock market would flop around for decades as it waited for dividend growth to catch up to it. We’ve seen this sort of market before. From 1966 to 1983 the Dow Jones was a snooze fest. Except for a few harrowing dips, it went sideways and grinded down even the most optimistic bull.

To avoid such a stark reality, I say the Fed should re-inflate like it was 1999 - Disclosure: I’m massively long seaweed CDOs.