Bear Market Valuations, Conditions Saying Market Not Cheap
By See It Market Jan 04, 2013 4:30 pm
A closer look at current stock market valuations and support for why the market is overvalued here.
Condition 2: Dividend Ratio at or below 10
The next classical measure of value is dividend yield. This measures real cash flow that companies pay their shareholders for owning their stock. True value investors know that when they buy shares in a company, they are buying its dividends, which generate cash flow. We can pay too much or very little for those dividends depending on where we are in the market cycle. If we buy shares when the market price is high and the dividend yield is low, it may be that investors are too enthusiastic and are paying too much. When we buy shares when the dividend yield is high and investors are despondent, we can buy great values and get dividends on the cheap.
There's still a desperate linger of speculation disguised as "investment," though. Too often I talk to people about buying stocks and their first notion is that they want the stock to rise. I then have to try and explain that the stock could be priced at $5 and falling because the company makes no money and has no dividends.
I will admit that the data shows the overall trend or skew of yields has been lower over time since companies have started using other tools to create returns for shareholders, such as share buybacks, options, or convertibles. I have also noted that the total return including reinvested dividends during the 1982-2000 bull market was as high as or higher than prior bull markets. And it may be that we have not seen the dividend yield increases that we've witnessed in prior bear markets due to the same phenomenon.
However, I have been witnessing an increasing appetite for dividend-paying stocks and funds as it seems investors are slowly starting to realize that long-term equity returns have historically been generated via dividend reinvestments, not just nominal price increases. I would expect that dividend yield on the S&P 500 will reach at least 5% before this bear market is finally over.
Condition 3: Tobin Q Ratio at or below 0.40?
The last valuation measure I want to showcase is the Tobin's Q ratio. The Q ratio is a company's market value (determined by financial markets) divided by its book value (published in financial statements). The Q ratio for the broad market can be calculated using data published by the Federal Reserve called the Flow of Funds Accounts. When the gauge is more than one, it indicates the market is overvaluing company assets, while a Q ratio of less than 0.50 signifies shares are undervalued because it is cheaper to buy companies than to build them from the ground up. At the end of the four largest US bear markets in 1921, 1932, 1949, and 1982, the Q ratio fell to 0.3 or lower. Currently the market is overvalued again based on Tobin's Q with a reading of 0.92. It can be reverse calculated that the S&P 500 would have to fall 34% or 45% to be fairly valued from its current levels. Again, this signals that major bear market valuations may not have been met.
Source: Picture from Dshort.com
No positions in stocks mentioned.