Market Mini: What Dividend-Price Ratios and Timing May Mean for Stocks in 2014

Posted By on Dec 26, 2013|0 comments

With stock markets reaching record levels and the call for continued growth in the economy and the stock market, I thought it would be a good time to revisit work completed by John Campbell and Robert Shiller, titled “Valuation Ratios and the Long-Run Stock Market Outlook” from the Journal of Portfolio Management in 1998.

Their work indicates that the stock market is not as random as the efficient-market hypothesis may lead us to believe. In fact, the dividend price ratio and the price relative to earnings over 10 years (CAPE) does an excellent job at predicting subsequent returns over the next 5, 10 and 15 years.

In 1997, the dividend-price ratio was 1.9% and the CAPE was 28 times the earnings. Today the dividend-price ratio is at 1.8% and the CAPE is at 25 times earnings. At the time of their analysis in 1997, Campbell and Shiller stated that the stock market would lose two-thirds of its value. The market did decline by 26%, but not before increasing by 45%.

According to their research, “There have always been special circumstances that are adduced every time the ratios have been at extremes that in the past have allowed people failure to heed the message of the ratios.”

In 1998, low interest rates and the development of the internet helped create a story for higher stock prices. Today, stock prices are dependent on low interest rates, quantitative easing and the belief that companies can maintain profit margins at record high levels.

Doug Short has plotted 1,593 data points originating back to the 1870s. According to his analysis, we are currently at the 90th percentile, which means there is a 10% chance of the market increasing. There were two periods of time when this occurred: 1929 and 2000.

There are many important points to understanding market increase; one is that this data has always been correct, however, the timing is very difficult to find.

Campbell and Shiller stated: “On previous occasions when the dividend-price ratio has been below 3.4%, the stock market has always declined in real terms over the interval to the next crossing of the mean dividend ratio.”

But as Campbell and Shiller experienced in 1998, the stock market continued to increase for two more years and by a drastic 45%. Consequently, timing is difficult.

Certainly the last 140 years of data may not hold up in the future, nor can the timing of the return to mean prices be fully understood. As a result, this makes the job for financial advisors more difficult.

As a sales trainer for financial advisors, I can only instruct advisors to provide clients with the evidence and give investors options that relate to their risk capacity, risk perception and risk tolerance.

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