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Post-apocalyptic movies have become popular, starting years ago with Mel Gibson's "Mad Max" series. The premise is a nuclear war, plague or alien invasion followed by a depopulated and technologically regressed future for those who are "left behind." My premise is that the financial world has been through such an apocalypse and the current market has to be analyzed with this in mind.

In the 2008 Panic, we had:

1. The elimination of three out of five free-standing full service investment banking firms (Merrill, Bear and Lehman),

2. The rescue of the two mortgage giants by the Treasury,

3. The extraordinary rescue of the flagship of the insurance industry whose AAA rating was considered rock solid,

4. The revelation that a stable and prestigious hedge fund operated by a renowned and well-connected financial professional was, in fact, a naked Ponzi scheme,

5. The elimination of two of the top ten depository institutions (WAMU and Wachovia), and

6. An incipient bank run on money market funds.

In a sense, we had more action in a few months than we have had since the end of World War 2. This explosion has resulted in a fundamentally different approach to the market by investors and professionals. In the early stages, there was extreme risk aversion resulting in extraordinary spreads between treasury rates and rates on corporate bonds. As investors have begun to regain their balance, there has been an effort to establish concrete assurances of value in deploying funds.

In this regard, it must be remembered that a stock certificate is a piece of paper and that its holder can be paid in only three ways - dividends, share redemptions or the sale of the piece of paper to another investor. It is not surprising that the valuation of equities has come to be centered upon the most immediately verifiable of these three - the payment of dividends.

Since the Fall of 2009, the S&P 500 has traded in a very narrow dividend yield range centered around the 2 percent metric. At times dividend yield has gone as high as 2.20 per cent and at other times it has gone as low as 1.76 per cent but it has generally returned to the middle of the range fairly quickly. This stability may seem surprising because the market has moved up so sharply during this period but, in fact, almost all of the run up is explainable due to higher dividends, which, if the dividend yield stays the same, inevitably result in higher stock prices.

This metric makes sense in light of the investors' desperate hunger for yield. Once it became clear that dividends were relatively safe and were actually increasing, a 2% dividend yield (with double digit annual dividend increases) began to look very attractive compared to fixed income alternatives. Bear in mind that 2% is the Index average and it includes some large companies which do not pay dividends at all - for example, Google (NASDAQ:GOOG) - and some banks, which are traditionally substantial dividend payers but are now rebuilding capital - for example, Citigroup (NYSE:C) and Bank of America (NYSE:BAC). The yield for stocks, which are actually paying dividends, is significantly higher than 2%. As the Index yield approaches 2.20%, there are a number of individual stocks whose yields start to approach or exceed 4%, which makes them very attractive to yield oriented investors.

The Table below provides quarterly and current S&P 500 dividend yield data (as of the first of each respective month) based on calculations from S&P data. There are a variety of ways to make this calculation but they all tend to lead to the same result. Dividends have been increasing at double-digit rates for at least two years now and this has propelled the market to new highs.

DateDividend Yield
10/092.19%
1/101.98%
4/101.83%
7/102.05%
10/101.92%
1/111.79%
4/111.78%
7/111.86%
10/112.12%
1/122.06%
4/122.00%
7/122.11%
10/122.10%
1/132.13%
4/132.07%
7/132.02%
10/132.00%
12/4/131.92%

Viewed from this perspective, the market was probably undervalued as of the Fall of 2009. Trailing 12-month dividends continued to decline until March/April 2010 but the market was sustained by lower dividend yields, which maintained price levels. Starting in the Spring of 2010 we began to have net trailing twelve-month dividend increases, which began to be robust in mid to late 2011. Since then, we have been humming with dividend increases at the rate of roughly 15% a year or a little better than 1% a month. In mid-2011, the market got ahead of itself with very low dividend yields (meaning very high stock prices) leading to a correction that Summer. In the Fall of 2012, dividend yields hit the 2.20% level in November, which should have been a powerful buy signal because it is the very top of the dividend yield range.

Of course, the big question is - where do we go from here? We are below the mid-point in the range and so a correction is likely. The market would have to move down roughly 4% to get to the 2.00% dividend yield level. But time is the friend of the Bulls here. Dividends are likely to increase at a healthy pace for at least another two or three years. Corporations generally have healthy balance sheets and payout ratios are still conservative so that increases can be funded without undue risk. At the current rate, dividends are increasing roughly 1% a month so that stock prices have to increase steadily to keep dividend yields constant. This trend should continue as corporations increase dividends and investors continue their aggressive search for yield. However, in the long term, annual dividend increases in the 15% range are simply not sustainable. Earnings are very unlikely to increase at anything like that rate and a corporation can't increase dividends faster than earnings for very long without running into funding problems. Investors should monitor the rate of dividend increase trend carefully.

In addition, higher interest rates could lead the dividend yield to increase (and stock prices to decline) as bonds become comparatively more attractive yield vehicles. However, it should be noted that the low dividend yields in the table above coincided with 10-year Treasury rates considerably higher than the present rate (for example, in April 2010, the ten-year treasury bond yielded 3.84% and in February 2011, the yield was 3.58%) and, thus, an increase in the 10-year rate does not necessarily suggest an increase in the dividend yield (or a corresponding decline in stock prices).

In the short term, investors should watch the dividend yield number and should get nervous when it gets down toward 1.8%; by the same token, investors should "back up the truck" and load up on stocks when the yield gets up to 2.20% (as it did in November 2012). In the intermediate term, investors should monitor interest rates and the annual rate of increase in dividends (currently running at 16%). If this rate decreases (as it almost certainly will), that may be a sign that investors will demand a higher current dividend yield.

This model seems almost too simple to command intellectual respect but it seems to have proven eerily accurate in the wake of the Apocalypse of 2008. And it makes sense because it is focused on the immediate return an investor gets from stocks. In apocalyptic movies, the survivors huddle around fires and congregate near water sources - struggling to survive. They choose allies and sites based on the immediate and urgent need to obtain the basics of survival. Post-apocalyptic investors are buying stocks as a source of yield. One hundred dollars is not a bad price to pay for a piece of paper, which generates $2 this year, $2.32 next year, and increases over time at that rate.

Disclosure: I am long GOOG, C, BAC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: This Post-Apocalyptic Market Metric Suggests A Modest Pullback Followed By A Strong Uptrend