http://www.economist.com/finance/displaystory.cfm?story_id=13382175
Here's another terrific Buttonwood column from The Economist of March 26 2009. The topic is valuation. Shares are not dirt cheap. They discuss dividend yield and price/earnings and some interesting ideas on relative valuation including equity risk-premium.
Here's a fact I found fascinating. American investors have an estimated $13 trillion - yep, that's trillion - sitting in money-market mutual funds. The bulls say this is hopeful. I think people are scared. Eventually, in my view, people will not buy stock.
VALUATION: The Economist's Buttonwood column of March 26 2009 ( linked inside dividendgrowth.ca) discussed valuation. If you are still waiting to buy, note that market dividend yields have been higher than they are now (8.7% in 1950). Price/earnings ratios, computed various ways, have been lower too (of the S&P 500 “ratio of around six in 1949”). These valuation measures, however, are not necessarily a good guide at market extremes. When earnings fall, p/e ratios can rise: when dividends are reduced, yields vary too. Andrew Smithers reckons, The Economist said, “that Wall Street is only around ‘fair value'.”
ADD YIELD and DIVIDEND GROWTH. On the other hand, if you want to buy a stock, you might consider this argument. I was most excited to see my favourite computation in The Economist. “A rough calculation for the forward-looking risk premium would be add the dividend yield of 3% to expected long-term nominal dividend growth (in line with GDP) of 5% and then subtract the ten-year bond yield of 2.7%. The result is a risk premium of 5.3%.” The Economist defines equity risk-premium as “the extra return investors should demand for holding shares”. “Since 1900”, according to Dimson, Marsh and Staunton at the London Business School, “the equity risk-premium has been around 4% a year”. Others, including Rob Arnott (I think…have to check) hold that the equity-risk premium is closer to 2.5%.
If you are thinking a buying a financial stock, add its yield, say 6.5%, to expected long-term dividend growth of 5% and arrive at close to 12%. (more if it's Canadian dividends). Is it worth the risk to buy stocks at 12%? Compare this to a money market fund with a yield of next to nothing and fees. If the dividend holds, and if dividends start growing again before too long, you'll have a comfortable retirement income and a market beating return when you opt for companies where profit output is reliable…never mind what happens to the price.
Button_Mar09f destined for April Connolly Report