The Market Is Overpriced But The Correction Will Likely Be Shallow

 |  Includes: DIA, IVV, QQQ, SPY
by: Philip Mause


The dividend yield methodology for valuing the market has been reliable for the five years since the Crash.

Under this methodology, the S&P 500 trades between a 2.2% dividend yield and a 1.8% dividend yield with a midpoint at a 2.0% dividend yield.

At Monday's closing price, the S&P yields 1.89% in dividends making it overpriced in comparison with the midpoint of the range.

A pullback to 2.0% would imply a correction of roughly 5% in the Index; a less likely result would be a pullback to 2.2% or a 14% correction.

The methodology should continue working until there is a major disruption in dividend flow or a major increase in interest rates.

I have written before, here, here and here, about the dividend yield methodology for valuing the market. Basically this methodology calculates the trailing 12 month dividends on the S&P 500 and compares this dividend amount with the current price of the Index to derive a dividend yield. Since October 2009 this dividend yield has persistently remained in a range between 1.8% and 2.2% with the center of the range being 2.0%. At Monday's closing price of $1978.91 for the Index, the dividend yield is 1.89% - somewhat below the middle of the range - which suggests that the market is modestly overpriced.

1. The Methodology - It is important to understand some specifics about the methodology. We are using the trailing 12 month dividend yield so that the actual yield experienced by an investor buying the Index on Monday would be higher as dividends have been increasing steadily. Because of the reliability of the methodology, it is fair to say that almost all of the appreciation in the Index since October 2009 has been due to increased dividends. That is, the market has increased as dividends increase in order to maintain the same dividend yield ratio. The ratio has also flashed buy and sell signals from time to time. In late Spring 2011, the dividend yield of the Index hovered around 1.8%, suggesting an overbought market. This turned out to be a good time to sell. By the same token, in late fall 2012 the dividend yield of the Index hit 2.2% and flashed a buy signal at just the right time to profit from the subsequent leg up.

2. Dividend Increases - Dividends have been increasing rapidly so that the price range for the Index has been moving up month to month. A glance at a typical issue of Barron's will reveal virtually no dividend decreases and multiple dividend increases with the list often requiring an appendix on a page not normally devoted to the topic. A good, back of the envelope way to think about it is that dividends are increasing at roughly 1% each month (or a bit more than 12% per year) - thus, if the middle of the range is at $1,869 (as it is now), one month from now it will be roughly $1,888 and one year from now it will be roughly $2,093.

3. Why the Methodology Works - The methodology has been uncannily accurate during this recent time period which, in many ways, is unique in financial history. Yield hunger has driven many investors to seek alternatives to the fixed income market and stocks yielding 2.5% or 3.0% with the dividends steadily increasing from year to year look very attractive in comparison with almost anything in the fixed income market. The overall yield for the Index is inevitably lower because there are a number of companies - some of them, like Google (NASDAQ:GOOG) (NASDAQ:GOOGL), large components of the Index - which do not pay dividends at all and these companies pull the overall average yield down.

4. The Current Range - At the current trailing twelve month dividend yield level, the methodology would suggest that the market will trade between 1699 and 2076 with a mid-point at 1869. As noted above, the methodology suggests that each of these price levels should increase by roughly 1% per month. Thus, an immediate correction to the middle of the range would imply a decline of 5.5%. A deeper decline to the bottom of the range would imply a correction of 14.2%. Because the range increases each month, a slow correction will meet resistance at a level higher than 1699 (by November, 1750) because of dividend increases. To get perspective, the bottom of the range in January of this year was at 1599 and the middle of the range was at 1759. The bottom line is that this methodology suggests that a 20% correction from here is very unlikely.

5. Disruptive Events - Various events could lead the methodology to become inoperative. Of course, considerably higher interest rates could make dividend stocks less attractive in comparison with fixed income alternatives and could lead investors to demand higher dividend yields. Another danger is a significant slowdown in dividend increases. One of the reasons that investors like dividend stocks is that many companies have reliably increased their dividends at a healthy pace and so an investor comparing a stock paying a 2.5% dividend which increases at 7% per year with a 3.25% 30-year Treasury bond can anticipate receiving much more money in dividends on the stock than interest on the bond over the 30-year life of the bond. If the expectation of dividend increases were to be dispelled or seriously reduced, investors might demand higher immediate dividend yields on stocks. More plausible than either of these events is another possible scenario. In the summer of 1982, Consolidated Edison (NYSE:ED) surprisingly cut its "reliable" dividend in half and the entire utility sector took a bath in the market. Today, investors seem to have forgotten that dividends are discretionary and that management can decide to cancel or reduce dividends. A surprise dividend omission or reduction by a company previously regarded as a safe and reliable dividend payer could disrupt at least that company's sector of the market. For example, if Exxon (NYSE:XOM) decided to cancel or reduce its dividend, the entire energy sector might experience a steep decline. I do not regard this as a likely scenario but investors should be aware that the market is priced for the expectation of dividends increasing at a reliable rate and a disruption of that expectation could have major effects on equity pricing.

6. The Long Run - In the long run, it is likely that 12% annual increases in dividends will not be sustainable. Dividends cannot grow faster than earnings unless payout ratios increase and at some point higher payout ratios will reach a ceiling. Earnings cannot grow a great deal faster than nominal GDP for a long time. Nominal GDP is not likely to grow at 12% per year in the foreseeable future. Therefore, at some point, dividend growth will decline and this may make investors demand higher immediate yields. However, the decline in dividend growth may be at least several years away as a combination of higher dividends from large banks, strong balance sheets, companies initiating dividends - as Apple (NASDAQ:AAPL) did a couple of years ago - and financial engineering allow the Index dividends to continue double-digit increases. By that time, the rate of increase slows down, dividends may be at much higher levels so that an increase in dividend yield may result in the Index being priced at levels much higher than the current levels.

7. Investment Implications - Investors should continue to hold stocks which reliably pay and increase dividends. I'm especially fond of stocks with balance sheet cash because this provides a further assurance of dividend increases. I still like the large-cap tech stocks with balance sheet cash including Apple, Microsoft (NASDAQ:MSFT) and Cisco (NASDAQ:CSCO). Exxon and Johnson & Johnson (NYSE:JNJ) are also very reliable dividend payers and should outperform in any kind of pull back.

Disclosure: The author is long GOOG, AAPL, MSFT, CSCO, XOM, JNJ. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.