Hindsight is a wonderful thing: It is easy to pick the points to enter and exit the market, Superbowls have no surprises, and, yes, your parents were probably right after all. Hindsight is also part of the cumulative experience and offers another data point to consider. Looking at today's markets is quite challenging with uncertainty in the financial systems, a struggling economy, and unending turbulence in Europe. Should I buy or should I sell? Is there any way to make sense of the overall situation? Markets are down from their 2008 highs and up from their 2009 lows, which sounds reasonable to me.
Some people would say that the markets are driven by fear and greed - buy when everyone else is fearful and sell when everyone else is greedy. In hindsight, these moments are particular obvious, not because of the result, but often because it takes distance to develop the perspective of what real fear and greed actually look like. However, I prefer to try to use some tools to make sense of the market. To me, fear is risk and greed is growth. We can observe interest rates and dividends. For the market, I'll look at the SPDR S&P 500 Trust ETF (SPY). The following graph shows its normalized performance and normalized trailing twelve months of dividends.
Source: Created from data from Yahoo Finance.
The first observation is that there are two significant periods of price declines. The first was after the internet bubble burst, which was further exacerbated by 9/11. The second was a result of the financial sector meltdown. However, the presence of the normalized dividend graph shows that the internet meltdown was a collapse in valuation multiples since the underlying fundamentals as measured by dividends did not really decline. Afterwards dividends began growing more rapidly and so did SPY.
The financial meltdown and ensuing chaos resulted in an anticipated substantial weakening of fundamentals in terms of dividends. ! This is not to say there were not also valuation issues, but the story here is fundamentally different from internet period. The last part of the graph shows that we have some dividend growth, but prices have dropped once again. Perhaps markets are anticipating some challenges in the fundamentals or perhaps valuations began to get ahead of the fundamentals again.
The dividend discount model can provide some insight to what a market multiple should look like. The multiple component is essentially equal to the inverse of the Equity Hurdle Rate less the Long Term Growth. So if the Rate is 10% and the anticipated growth is 5% the multiple would be 20x. (= 1/(10% - 5%) = 1/5% =20x). For the market as a whole, the Equity Hurdle Rate is just the risk free rate plus and equity risk premium. I use 6-8% for the equity risk premium and the 10-year treasury bond rate for the risk free rate. The following graph shows a historical equity hurdle rate:
Source: Created from data from Yahoo Finance and author estimates.
This is not very exciting, basically interest rates have simply been declining for the past 17 years. I applied a step change in the equity risk premium for post the financial crisis. These rates can then be transformed into a multiple by adjusting for growth and taking the inverse. I've just assumed a long term growth rate of 2% throughout.
Source: Created from data from Yahoo Finance and author estimates.
I've plotted the valuation multiple on a normalized basis. The first thing to note is that this is not a P/E multiple or an EBITDA multiple or anything like that, rather it is a theoretical multiple that looks to measure growth and equity hurdle rates and compare them over time. With the growth set a fixed value, the only variable is the equity hurdle rate. The next chart will put it all together. In theory:
Price = Dividends x Multiple
In thinking ! about th e stock market, investors are willing to pay some multiple for an underlying cash flow whether it is free cash flow, revenue, earnings or dividends. Free cash flow is most typically used. Dividends can also be used.
Source: Created from data from Yahoo Finance and author estimates.
So this is an interesting final graph. The actual performance of SPY is plotted in blue and the theoretical based on actual dividends and the calculated multiple is plotted in red. It clearly shows the growing disparity during the internet boom, a close tracking during the middle of the 2000s and then a huge drop in the spring of 2009.
What it doesn't do is predict collapses like the financial meltdown, while you see some spike up in 2007 it is not really that big and there were earlier spikes of similar size that had you exited, you would have left a lot of money on the table. The other problem is that dividends measured here are sticky since they reflect a trailing figure. So the Theoretical Price does not collapse as quickly as intuition would tell us it should. The theoretical price is more of a lagging indicator.
So what does this tell investors?
It says one of two things: Either the market is undervalued right now or dividends should have some sort of dramatic collapse. Having bumped the equity risk premium up 2% from the onset of the financial crisis (in hindsight the risk had been increasing all along) should account for the current challenges. So while Europe is a concern and the continuing stagnation in the U.S. is problematic, I lean towards the market being undervalued right now. I had earlier concerns this past spring that it had been overvalued from the small bump up suggesting the market. In light of this, I have increased my net long position through SPY purchases and am looking at select individual stocks.
Disclosure: I am long SPY.
Disclaimer: This article! is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security. You can now follow me on twitter @jtcbp.
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