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When stock prices get ahead of dividends, watch out

One U.S. advisory claims that a bloated price-to-dividend ratio tells you when trouble is coming — and how long the market will be in danger.

There are as many ways of looking at the stock market as there are experts to do the looking. There seem to be no end of charts, ratios and indicators to explain to us what has been happening.

Some of these measurements may even help us decipher what is going to happen before it happens, although investors can be forgiven for taking most predictions with a grain or more of salt.

Some indicators, however, are more intriguing than others. One that you’re not going to run across every day is the price-to-dividend ratio. Yet one U.S. advisory uses this ratio as a red flag that pops up again and again in overvalued markets.

Back in the spring, this same advisory, Growth Fund Guide, explained to us the principle of the Danger Zone (Daily Buy-Sell Adviser, June 18, 2007). According to historical figures, a Danger Zone has cropped up in the stock markets in the sixth or seventh year of every decade since records have been kept — often in the 10th month of the 7th year.

Back in June, as it warned of upcoming danger, the advisory pointed out that the price/dividend ratio was abnormally high.

No one can deny that danger raised its head in the seventh year of this decade. The question is, how long will it last into the eighth year? Let’s see what the advisory is telling us about the crisis today.

Overvalued at $30

One of the reasons you won’t see the price/dividend ratio quoted more often is that this advisory invented it (although many others have picked up on it subsequently).

The price/dividend ratio was devised by Mr. Walter Rouleau, the publisher of the Growth Fund Guide, as a way of gauging an oversold market. Based on dividend yield, it basically tells you how much you will pay for a $1 worth of dividends. When the price is around $20, the market is undervalued. When it goes over $30, the market is overvalued.

Historically, the average price/dividend ratio on the value-weighted New York Stock Exchange is 25, according to the Federal Reserve Bank of San Francisco. This advisory uses the S&P 500 Index as its guideline. The historical average on that index has been 27.9 per cent since 1900.

Every time this ratio has reached the 30s over the past century, a market decline has followed, says the Growth Fund Guide. But it is not the only factor. Another important figure to consider is how many days the market rose before it hit at least a 10 per cent correction.

Taken together, these factors should supply clues as to how the current decline should work out, states the advisory.

Mesmerized by bullish spin

How we got in seems pretty obvious. Following the bear market of 2000-2002, a mini-bull market started. The advisory admits that this bull run lasted longer than it had originally expected, thanks to a supporting layer of hot air.

“We believe it lasted so long,” says the advisory, “because of the consistent bullish spin by the powers-that-be and the media. Bullish complacency was easily maintained because of the housing boom that was driven to unbelievable extremes by interest rates that were kept too low for too long by the Fed, as well as the most lenient lending practices ever seen.”

Expect several books to be written about the current crisis, say the advisory.

“Mesmerized by their own consistent bullish spin,” the powers-that-be finally woke up in late January, trying “in a hurried emotional way,” to act as the saviours who would prevent the dangers they had at long last recognized.

The overextended mini-bull market ended right on schedule when it reached its high on October 9, 2007, almost exactly five years after it began. The problems finally overpowered the spin.

The five-year bull market revealed another interesting phenomenon. Although the mini-bull market did not produce large gains in purchasing power for most securities relative to the preceding bear market, says the advisory, “what we have witnessed over the past two years or so suggests that we should never underestimate what interest rates kept too low for too long … can accomplish, at least in the longevity of a market rise.”

Here’s where the numbers come in.

$55 for a dollar’s worth of dividends

To understand market declines, look at how long the market rose before a correction of at least 10 per cent began, says the advisory.

It publishes a table of the longest stock market rises preceding a 10 per cent decline, accompanied by the price/dividend (P/D) ratio registered on the S&P 500 Index at the time.

The recent rise lasted for 1,128 days, the second longest such rise in history. And the price/dividend ratio was up there with it: at 55, it was the second most overvalued among all the examples given.

In short, by the time the bull market had run its course, it cost investors $55 to buy a dollar’s worth of dividends. What does this tell us?

“The data on the table seems to be suggesting that the current decline in the U.S. market could end up being larger than most expect.”

The longest rise was in 1997, a 1,723-day climb. It concluded with the highest P/D ratio on the table, 62. It was followed by a decline of 13 per cent. Even more important, it was followed several years later by a super bear market. That, of course, came on the heels of the dot-com bubble.

Studying the table, the advisory points out that all but two of the 10 market declines shown (1953 and 1957 are the exceptions) began with very high P/D ratios. In September 1929, for instance, the ratio hit what was then a new high at 35. We know what hit a month later — the biggest crash in history.

“This strongly suggests that the majority of investors have a habit of being very bullish as the market approaches extreme overvaluation,” adds the advisory.

A severe decline?

In fact, this advisory’s figures suggest that one market peak accompanied by a high P/D ratio will be followed several years later by another peak with a similarly high ratio.

When the market rises for 600 days or more without a 10 per cent correction, you can expect to see the P/D ratio rise as well, until the two reach a level that can no longer be sustained. When the market peaked in 2000, for instance, it had a P/D ratio of 94!

The pattern that emerges from this advisory’s table “is suggesting that the current market decline could end up being rather severe.”

At this point, the advisory reverts to its Danger Zone tables (they go back to 1856-57). Keep in mind that there has been a decline in the sixth of seventh year of every decade since before the Civil War, or Confederation, if you prefer. Using the figures from this table as a basis for projection, we arrive at a rather unhappy conclusion.

Could the current decline end in February or March, as several have before? Don’t count on it, says the advisory. This decline could be larger than the average of all the other declines.

This one may not bottom out until October 2008, concludes the Growth Fund Guide.

That’s just a projection, of course. But thus far the advisory’s rather unusual tables have shown an uncanny knack for forecasting trouble. And while we would hardly expect investors to keep track of how many days the market has been going up without a 10 per cent correction, or the daily progress of the price/dividend ratio on the S&P 500, these figures appear to hold some weight in predicting an overvalued market.

And if we could indeed be sure that the market won’t pull out of its decline until October, at least we would know what kind of market we had to deal with for the next seven months or so. Investors could trim their sails and buy on weakness, as this advisory suggests.

On the positive side, it’s quite a ways to 2017 and the next Danger Zone.