Stocks: A Bear Case

by: Felix Salmon October 25, 2008 | about stocks: DIA / QQQQ / SPY    
Felix Salmon

Felix Salmon

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If stocks fall, that means they're cheaper than they were. And if they've gotten cheaper, they must be a better investment, right? That's the gist of a blog entry from Jim Surowiecki today.

But that's not necessarily how this is going to play out. It's true that stocks have been a good long-term investment in the past, but that doesn't make them a good long-term investment in the future, even if they are looking cheap(ish) these days. And to understand why, it's worth looking at a very old-fashioned indicator: the stock market's dividend yield.

As Steve Waldman rightly points out, the vast majority of investors aren't speculators trying to maximize their net worth. Instead, they're trying to maintain their standard of living post-retirement:

Our current system does not serve savers well, because our markets offer inadequate ways of purchasing claims on future consumption (as opposed to claims on future production).

But for many decades, it was fair to assume that stock dividends, in aggregate, would rise more or less in line with the cost of living. When you bought a stock portfolio, you were buying a payments stream -- one which, you could be reasonably sure, would increase steadily over time. As such, some stock-market investors actually liked it when stocks went down, because that meant that buying future payments had just gotten cheaper, and you could buy more of them.

In the late '70s and early '80s, the S&P 500's dividend yield was over 5%, and it was not uncommon to find retirees living off their dividends. Even though the stock market was at depressed levels at the time, it had actually proved to be a perfectly good investment, because many shareholders cared only about the amount of their dividends, not the price of their stocks.

Then, however, things began to change. Stock prices started to rise much more quickly than dividends, making that future earnings stream much more expensive. And good stock market investments turned out to be not those which reliably paid a bit more in dividends than they had the previous year, but rather those which had increased the most in price. An entire stock-market sector -- tech stocks -- was created on the tacit understanding that most of them would pay no dividends at all, most of the time. And the most admired man in the stock market, Warren Buffett, also abjured dividends entirely.

In the mid-1990s, about the time that Alan Greenspan first started warning about "irrational exuberance", dividend yields dropped below 2% for the first time, and they stayed there even through the dot-com bust. People had long since stopped buying stocks for their dividends: Now, they were investing in the expectation of future capital gains.

A stock portfolio wasn't something you could live off, any more: The only way to do that would be to sell it down over time. Equities might still be permanent capital from a corporate-finance point of view, but from the point of view of an individual investor, they were bought only to be sold, at a higher level, in the future, to someone else.

This worked for a long time. As defined-contribution pension plans replaced defined-benefit schemes, and as a generalized unanimity emerged that stocks were the first best place to put retirement savings, the flow of money into the stock market was more than healthy enough to keep prices rising and to justify people's faith that they would continue to do so indefinitely.

But if stock prices start falling year after year, then it will become increasingly apparent that it's not reasonable to expect long-term capital gains. Yes, stock prices have generally risen over the long term. But for most of the decades in question, people never really expected them to do so.

There's a word for an asset class which everybody expects to continue to rise in perpetuity: a bubble. And although stocks are down a long way from their highs, the idea of stocks as something to buy today and sell for more money tomorrow is so deeply ingrained in the national psyche that a few months of market volatility is nowhere near enough to erase it.

So consider this possibility: that stocks will continue to fall until their dividend yield reverts to its long-term historical mean, somewhere around 3.5%. At that point, people will start buying them not for capital gains but for income, and I think it's reasonable to expect a stock-market floor at roughly that level. From then on in, both prices and dividends would be expected to rise at roughly the same pace as national GDP.

Of course, there would still be volatility. But that doesn't mean that there's likely to be "exceptional performance in the future," in Surowiecki's words. Indeed, stock-market performance might be downright mediocre. Which might not be such a bad thing.

Update: The wittily-named "Modigliani_Miller", in the comments, points out that in a world where investors prefer capital gains to dividend income (which is probably any world where the capital gains tax is lower than the income tax), companies can simply return money to shareholders through share buybacks rather than dividends.

On the other hand, there's also this, from dWj, which makes my case positively sunny:

There used to be a rule of thumb that stocks were expensive when the dividend yield got down to 3% and cheap when it got to 6%. By this measure, after 12 years, stocks are finally down to "expensive" again -- and will be cheap when they lose another half of their value, supposing the dividends aren't cut too badly. (I've been using $25 per S&P 500 lately when doing dividend calculations, which assumes dividends only drop about 15%. We'll see about that.)

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This article has 14 comments:

  •  
    Oct 25 08:23 PM
    MLPs are yielding 12-15% - much higher than they have traditionally yielded, even in a world oriented towards capital gains, and much higher than I think they will yield once more people realize what Salmon is writing.
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  •  
    Oct 25 09:24 PM
    The only reason to buy stocks is the dividends. Nearly all real returns come that way. Why? Simple: the return on equity is much greater than the rate at which the economy grows in real terms. Virtually all capital gains are a byproduct of monetary expansion and do not reflect a real gain. Since monetary expansion occurs at several times the rate of real growth, capital gains in nominal terms are completely irrelevant for index investors and trivial for investors in all but the smallest companies. This system suits the government and central bankers well; they can capture enormous tax revenues even at low rates because the money they are being paid is just cycled around from the printing presses. The real losers are speculators in non-dividend stocks who consistently lose 2-3% of their investment every year even while the price of the shares in dollars is rising. It's a nifty scam but you'd have to be retarded not to see through it.
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  •  
    Oct 25 09:45 PM
    100% agree it should be true. but the market is geared to reward speculation to the point the long term investors get burned. the vehicles of leverage such as puts, calls and shorts need to be carefully thought out if we want a market which is friendly to investors. not in a million years will these leverage vehicles be controlled because with the exception of a few on wall street - most of the big players like it the way it is. the little guy just wants to buy a good stock and hold it - and let it appreciate and yield dividends. the big boys such as the brokerage houses and banks want momentum and sales volume - as this is their profit vehicle.

    my second point is that the market rewards companies and executive officers who maximize short term profits. the company executives are focusing on too short of an horizon for long term viability of their companies. my bet is there is not one ceo working to a ten year game plan - and none working to a plan longer than their contract. this makes long term investing impossible.

    so felix, even though you are right about what should be - the long term investor which was the group which built up our economy - is going the way of the dinosaur. maybe we could reconstitute the market more in the way it has become - just one big casino.
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  •  
    Oct 25 09:58 PM
    Great article, and excellent well-thought out commentary below.
    Reply | Link to Comment
  •  
    Oct 25 10:08 PM
    Good article Felix. Few have made the point of noting the change in rationale for holding stocks as a means of financing retirement. For those who believe that rising stocks will provide them with profits to live on, keep in mind that the baby boomers will all be trying to sell for that purpose at the same time. That's a lot of sellers (and not many holders for dividend income).

    Also, the difference in taxation on capital gains (15% long term) and dividends (regular income rates) is one driver toward the "buy to sell higher" mentality.

    There is another reason to remember as well for the drift away from large dividends as a 'normal' course of affairs. Dividends are not counted as expenses in corporate affairs. Profits earned and paid out as dividends are taxed at both the corporate level and the personal level. This provides incentives to minimize dividends and instead retain the profits in the company and increase share values instead.

    As might be expected from the law of unintended consequences, gub'mint changes to reward "long term" holders of stocks (lowering capital gains tax rates) have instead resulted in the near elimination of the payment of dividends and their use to fund a long retirement, replacing it with the bubble mentality of chasing capital gains, much to everyone's detriment.
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  •  
    Oct 25 10:18 PM
    bearfund makes a valid point as well. The years when dividends were the typical reason for funding retirement with stocks were back when the dollar was much more stable than it is currently.

    It is only the modern fiat era (since Nixon closed the gold window) that currency has begun to lose purchasing power at unthinkable speeds. A steady dividend in 1910 retained or gained purchasing power over time as the general costs of living declined when measured in stable money.

    When your money is depreciating at 3% or 4% per year there is no way to grow the dividends fast enough to keep up and they buy less and less every year until it becomes necessary to sell the stock to meet living expenses.

    We can thank the FED for that state of affairs.
    Reply | Link to Comment
  •  
    Oct 25 10:21 PM
    Smarty,
    As usual you make excellent points. One reason I could never "buy to sell higher" is: What good is a company now if it doesn't have a good dividend and why should it be worth more later even if it grows? What good is it to the average investor to vote his puny number of shares? Thus, I had the good sense and poor luck to miss every bubble. But musical chairs was always a game I detested.

    Still, I watched my friends get 20% gains year after year while I earned a mere 9% in a guaranteed income fund.

    Reply | Link to Comment
  •  
    Oct 25 10:37 PM
    People will buy when dividends = 3.5% ? Why should they take a dividend less than the inflation rate? How about inflation adjusted dividends (and I don't mean using the government's phony numbers)? Until we get interest and/or dividends above the true inflation rate won't people be driven to more speculation?

    If loathing could kill...
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  •  
    Oct 25 10:51 PM
    Bearfund nailed it - dividends and covered calls are everything for anyone who holds stocks for more than a few months at a time.
    Reply | Link to Comment
  •  
    Oct 25 10:53 PM
    moonbat - it's the dividend increases that make the difference. It's the 3.5% that turns into 20% 10 years from now that matters.
    Reply | Link to Comment
  •  
    Oct 25 10:56 PM
    Excellent analysis. Unfortunately for us, the government tax policy favors capital appreciation over dividends. The nature of economic forces so unleashed is of a destabilizing nature due to positive feedback (higher stock prices attract more participants). On the other hand if investors sought dividend yields instead, it would automatically create a negative feedback leading to stability in the financial system. At least in the field of Engineering, Autopilots to Transistor circuits are stabilized using negative feedback loops. Positive feedback loops in these systems lead to immediate instability. One way that the government could ensure stability in the financial system would be to require all companies to pay at least 25% of their declared earnings as dividends. This would have the added benefit of making sure that the stated earnings were reals and not made up. Individual investors could then decide whether to use the dividends to purchase more company stock, to diversify into other stocks or to purchase goods.
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  •  
    Oct 25 11:40 PM
    LCACM, in the world of finance, negative feedback would simply mean raising interest rates when the availability of presumably cheap assets stimulates more demand for borrowed money, and lowering them when assets are perceived to be expensive and no one wants to invest. That's a fancy way of saying that a fixed monetary base and market rates do exactly what you want. So much for fiat paper and central bank wizardry, eh? Turns out the best countercyclical actor is the free market.
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  •  
    Oct 26 03:53 PM
    When the dividend is paid out of cash flow and is not limited to earnings my experience has been that the price of the stock falls accordingly. I have just been given back my capital and asked by IRS to pay tax upon receipt.

    Look behind the dividend to see its funding souce: profits, depreciation cash flow or new debt.
    Reply | Link to Comment
  •  
    Oct 26 08:05 PM
    Felix has written a useful article debunking the slogan " stocks for all time". His "bear case for stocks" may turn out to be prescient ie stocks might not be attractive until the sp500 dividend is 5% with the index half from present levels.

    We must invest based on reality and not slogans like "cash is trash".
    Reply | Link to Comment
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