Dividends are no longer merely a welcome add-on to a rising stock price; they’re essential
I came across one of the best articles on investing in today's market that I have seen in a while last night while perusing Smart Money magazine. It was Jack Hough's monthly piece. I've always enjoyed his articles on screening for stocks, so much so that I purchased his book Your Next Great Stock (of course, I have yet to read it). I have been unable to find a link to the article on-line. It may only be in the print edition, so I have taken the time to physically type in an outstanding quote from it and to summarize the rest (that's how much I care about CAPS ;) ).
"Investors who stay in the market are doing the right thing – it’s still the best way to make money long-term. But change your strategy.
There used to be sheep in Manhattan’s Central Park. They were evicted in the 1930s, though not because after 70 years they had become troublesome tenants. Rather, city historians say that during the Great Depression, when more than a quarter of workers couldn’t find jobs and the nation’s hungry and homeless built shack towns in public spaces, the sheep were feared too tempting a meal.
America has seen far worse than the next few years will bring. That’s not to say that stocks will recover quickly: Investors should be cautious, since losses in the financial economy have yet to fully affect the broad economy. Plus, despite appearances, the broad market’s value might be merely fair and not illogically cheap. But a handful of companies now carry the slimmest valuations and richest dividend yields seen in a generation."
According to Hough, S&P 500 index currently sits at around 13 times trailing aggregate earnings. That is an attractive level when compared to the S&P 500's historic average multiple of 14.5, and especially when compared to the crazy 19 multiple that it has averaged over the past twenty years. Unfortunately, he points out and I concur that most analysts are still too optimistic about companies' future earnings. In the post World War II era, after-tax corporate profits have averaged 5.9% of GDP. However corporate profits had ballooned to an unsustainable level over the past several years. At the beginning of 2007, they had grown to over 10% of GDP. These statistics are enough to make one look at this year's 39% drop in corporate profits a little differently. Perhaps this is more of a return to a normal, sustainable level of profits than a temporary dip in earnings.
One has to be particularly pessimistic that profits will return to their recent highs when one looks at what sort of shape the U.S. consumer is in and how we got here. After adjusting for inflation, the average income of American families has not grown in more than thirty years, but fueled by cheap credit and soaring stock / home prices consumer spending has exploded. The recent precipitous fall in home prices and walloping that most investors' portfolios have taken, combined with a tight credit market should is and will continue to cause consumer spending to drop significantly.
Having spewed all of this doom and gloom, it's time for some optimism. I strongly believe that a fairly significant economic slowdown is priced into stocks at their current level. While some are scared off by high dividend yields, they often are a sign of a bear market bottom. Historically bear market bottoms are often reached when companies' dividend yields rise to 5% to 6%. Unfortunately, the S&P 500 currently yields only 3%. That isn't as bad as it initially looks though because stock buybacks are much more popular today than they have been in the past. If the money that companies were spending on buying back shares was spent on dividends, the yield would be around 5% to 6%, which is a buy signal.
I strongly believe that now is a good time for investors to dip their toe into the water and to begin buying stocks again. Don't throw all of your money into the market immediately looking for a quick recovery. Things will take time. Average in a little each month looking for companies with big dividends and even bigger free-cash-flow yields to help ensure that those dividends keep coming.