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Excerpt from the Hussman Funds' Weekly Market Comment (3/16/09):

On the valuation front, this week Bill Hester offers some historical perspective on stock market valuations during recessions (additional link at the end of this comment), emphasizing metrics that are not skewed by the abnormally high profit margins of the past few years. To expand on those, I've included dividends to the list of “smooth fundamentals” below.

As with S&P 500 earnings, S&P 500 dividends have historically followed a reasonably consistent growth trend of about 6% annually.

Recently, dividends on the S&P 500 have been plunging due to dividend cuts among major financials. As of last week, the dividend yield on the S&P 500 was 3.2%, versus a historical median of about 3.8%. From a dividend standpoint, that would imply that the S&P 500 is still about 20% above even median historical valuations.

A somewhat more constructive picture emerges if we normalize the dividend yield by using “trend” dividends (the red line in the chart above) rather than actual dividends. On that basis, the present dividend yield rises to 4%, while the historical median drops to about 3.4% (thanks to the omission of high yields based on above-trend dividends from the calculation). Unfortunately, even with this adjustment, 40% of historical yield observations are still above that 4% level.

A normalized dividend yield of 4%, coupled with long-term growth of 6% in normalized dividend yields, produces an extremely straightforward result, which is that at current levels, the S&P 500 is probably priced to deliver long-term returns of about 10% annually. To the extent that investors become comfortable with yields well below 4%, the returns from now until that point would tend to exceed 10% annually. To the extent that investors demand yields above 4%, the returns from now until that point would tend to fall short of 10% annually. In any event, it is difficult to view stocks as being extremely undervalued unless we assume a sustained return to the unusually elevated profit margins of recent years.

Source: John Hussman: Are Stocks Really Undervalued?