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.

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.

The PE ratio needs no introduction. For a very long term chart of the ratio, click on the image to the left. The source of the chart is the NY Times with a helping hand from the economist, Robert Shiller. I was surprised to see that we were trading at a higher PE ratio as early as last year, than the top in 1929!

The graph above is based on the average earnings for the preceding 5 years. This chart is more short term, based on the rolling 4 quarters of earnings:

Why Use the Price Dividend Ratio?
I’m not sure where I first learned about this ratio. But Stan Weinstein really made it stand out for me as a very important measure of market valuation in his book: “Secrets For Profiting in Bull and Bear Markets” The power of this ratio comes from the fact that unlike earnings, dividends can not be “massaged” by creative accounting. There are no “EBIT” dividends. They are completely immune from accounting shenanigans. They are either declared and paid in cash or they aren’t.

Also dividends are free from the year to year shocks such as “write-offs” which can affect earnings. Most companies treat their dividends with what you might say approaches reverence because dividends send such a clear and strong signal about their financial strength.

I’m loathe to dip into the fundamental analysis toolbox but from time to time, when the situation warrants, I do. But for the reasons above, I prefer to use the price dividend ratio instead of the much more popular price earnings ratio.

Basically, the ratio tells you how much you have to pay for $1 of dividends. So in a way it can be equated to the “yield” coupon of the stock market. Or the inverse dividend yield of the stock market. And because of that, it has some correlation to the interest rate. So when interest rates are high, usually the dividend yield is also high.

Here is a very long term chart of the S&P 500 Index. I’ve added two data points, one for where we were this time last year and one for now:

Source: Federal Reserve Bank of San Francisco

Dow Jones Price Dividend Ratio
A year ago, when the Dow was at ~14200, the price dividend ratio was 49. Meaning you would have had to pay almost $50 to get $1 of dividends a year. It also corresponds very closely to the S&P 500’s price dividend ratio (above).

As of now, however, the Dow’s price dividend is a more reasonable 26. This is because of two things. First, and most obviously, the Dow has come down a lot, but also importantly, dividends have increased a healthy 11.7% from a year ago.

As you can see from this long term chart of the Dow’s price dividend ratio, we are right around the long term average for this ratio:

Source: John Bogle on Mutual Funds

As we’ve all noticed in the past few days, the market has the ability to reach maximum levels and then to keep pushing into new territory (I’m looking at you VIX). So just because we are now at a much more “normal” price dividend level doesn’t mean that it can’t go lower. For example, here’s a really scary picture of what might/could happen.

Having said that, I’m glad to see this fundamental ratio not clash with other technical indicators which are pointing to a potential market bottom.

The charts above are long term but do not show the most recent years, so if you know of a more up to date price dividend ratio, I’d love to see it. Or if you have access to a platform like Bloomberg, where you can look it up, send me a screengrab. I’m sure the most recent data holds some insight.