April 19, 2010
VALUING THE STOCK MARKET AS A BOND
No one should confuse stocks with bonds, but there's a case for valuing equities as if they were fixed-income securities. There are several caveats, of course, but that's always true with financial analysis. The question is whether there's anything to learn when it comes to analyzing stocks as would-be bonds? Yes, although it's not a silver bullet, nor is it helpful for short-term trading. And to the extent we do so, this valuation approach should be used simultaneously with other techniques. That said, there's something to be said for taking a page from the world of fixed-income when assessing the stock market.
This is hardly a new revelation. Financial economists and money managers have been telling us no less over the decades, albeit with varying twists. The latest comes by way of a new essay published at VOX, a research web site run by the Centre for Economic Policy Research. The dividend price ratio performs "very well" in predicting long-term equity market returns, advises "Demographics and stock market fluctuations."
As an example, the paper's authors show how the dividend-price ratio for the U.S. stock market is related to subsequent 10-year returns. As it turns out, the relationship, while not perfect, is surprisingly robust, as one of the paper's charts illustrates (see graph below).
The chart above suggests that high dividend price ratios are associated with relatively high stock market returns in the years ahead. Meanwhile, low yields tend to precede low returns.
In fact, this is a widely discussed relationship in finance. Dividends alone aren't a magic metric. More broadly, dividend yield is providing information also found in other fundamental measures. The research shows that a number of statistics offer comparable help in forecasting returns. Dividends are one, but earnings and book value are useful too. The bibliography on the general topic would be quite lengthy if we listed all the papers and books that discuss the details. A few examples: Robert Shiller's Irrational Exuberance and Andrew Smithers' Wall Street Revalued. And in my own book, Dynamic Asset Allocation, I review some of the research published over the years that finds a connection with current market valuations and expected return.
That includes Professor John Cochrane, who's been one of the leading academics shedding light on the link between dividends and expected returns. In a 2008 paper published in the Review of Financial Studies—"The Dog That Did Not Bark: A Defense of Return Predictability"—he writes, "If returns are not predictable, dividend growth must be predictable, to generate the observed variation in divided yields. I find that the absence of dividend growth predictability gives stronger evidence than does the presence of return predictability."
Cochrane has also observed that "stocks are a bit like bonds." By that he means that when the price-to-dividend ratio falls, expected return (as well as dividend yield) rises.
How is this connected with valuing bonds? Think of a 10-year Treasury Note trading today at a 4% yield. If you buy this Note and hold it till maturity, you'll receive a 4% return. But let's say you decide to wait a week before buying. During the interim, traders have bid up the price of the bond so that it's now yielding less--3.9%. At that point you say, too expensive, and so you wait. During that time, we learn that the inflation outlook has deteriorated and the market reacts by revaluing bonds at lower prices. The 10-year Treasury's price falls sharply and so its yield has jumped to 4.1%. At that point, you decide to buy and lock in a 4.1% return for the remaining life of the Note.
The same relationship between current yield and expected return applies to the stock market, albeit with some caveats. The first is that there's quite a bit more risk surrounding dividends with equities vs. payouts from bonds. In addition, equities have the equivalent of infinite maturities. As a result, we must be far more skeptical about current yield when it comes to stocks vs. bonds. Nonetheless, some of uncertainty goes away if we're buying a broad basket of stocks vs. individual companies.
Another risk-management tool is building equity return forecasts from a variety of sources. The research literature is also quite clear on the value of forecasting return using a mix of variables. Indeed, the Vox essay noted above reports that combining dividend yield with demographic data may offer a richer forecast than dividends alone.
As we wrote last month, the case for so-called combination forecasts is compelling. That is, using a diversified mix of return predictors is superior to relying on one. That's just common sense, of course, although financial economics is beginning to flesh out the details on a more formal basis.
Dividend yield is certainly a worthy factor to consider in the dark art of forecasting return. It's far from foolproof. What's more, the power of its embedded outlook waxes and wanes through time. That implies that we need to find complimentary predictors that can minimize the inherent hazards of peering into the future. Investing success, in short, is built one brick (and return predictor) at a time.
There are no guarantees in predicting returns, but that doesn't preclude the possibility of reducing the magnitude of the nefarious error term. The devil, of course, is in the details...and in the particulars of the forecast.
Posted by jp at April 19, 2010 10:24 AM
Yes, the original chart from the paper seems to have mistakenly inverted the left-hand scale. The relationship, however, looks about right in terms of the red and blue lines. Basically higher (lower) dividend yield is linked with higher (lower) future return. For a better graph of the same relationship, take a look at the chart from an earlier CS post:
This was part of the article from Jan 27, 2010:
Posted by: JP at April 20, 2010 2:09 PM
I'm confused by the chart. Both series use the right scale? Then what's the left hand scale and why is it negative?
Posted by: Aaron Schindler at April 20, 2010 11:26 AM
Thanks. As to your question, you find the next post useful.
Posted by: JP at April 20, 2010 10:42 AM
Well done as always. Given this post and your last month post on combination forecasting, any logical guess as to the annual rate of return we can reasonably expect over the next 10 years?
Posted by: Brett Alexandera at April 19, 2010 11:25 AM