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Momentum and perception are the big intangibles of the investing universe. Nobody knows exactly when the investing masses' mojo will turn on or off, overheat or over correct.
Valuations, similar to gravity, are the big equalizer. In a world of uncertainty, valuations are the one thing you can rely on. Getting valuations right is one thing, figuring out when valuations will exercise their gravitational pull on stocks (NYSEArca: SCHB - News) is another.
Using Valuations as a Guide
When planning a trip from point A to B, you need to know where A and B are. If you don't know your destination, you will most likely end up some place you don't want to be. Failing to prepare is preparing to fail.
Fair valuations are the final investment destination (point B). If you invest in an undervalued market or stock and have the patience to let the market do its magic, your investment will be profitable 9 out of 10 times.
If you invest in an overvalued market and don't get out in time, odds are that your journey will end in tears.
Asking the 'Valuation Guru'
Charles Dow, the founder of the Wall Street Journal and inventor of the Dow Jones Averages, was an astute student of valuations. According to Mr. Dow, a correct understanding of valuations is the single most important ingredient to investment success. If Mr. Dow was still alive, what would he say about today's market? Would he tell you to buy or sell?
Let's examine the most basic and probably purest measure of value: Dividend yields.
Unlike P/E ratios, dividend yields can't be fudged and massaged (more about that in a moment). Companies with a healthy cash flow use their financial prowess to attract and retain buy-and hold type investors with juicy dividend checks.
The dividend yield is expressed as a percentage of the stock price and can rise for two reasons: 1) stock price drops or 2) dividend payment increases. As a rule of thumb, the higher dividend yields, the healthier valuations.
Dividend Yield - Buy High, Sell Low
It's human nature to want what you can't get. Current yields are low, but everybody wants income, so investors are willing to risk the return of their money for return on their money. The sharp decline in municipal bonds (NYSEArca: MUB - News) may be a taste of things to come. Current yields are close to an all-time low, historically that's a sign that stocks (NYSEArca: IWV - News) are overvalued.
The opposite was true in the first quarter of 2009. A variety of ETFs yielded close to or even more than 10%. The Financial Select Sector SPDRs (NYSEArca: XLF - News) and iShares DJ US Financial ETF (NYSEArca: IYG - News) paid more than 7%.
Dividend ETFs like iShares DJ Select Dividend (NYSEArca: DVY - News) had yields north of 6%, and even plain value ETFs like iShares Russell 1000 Value (NYSEArca: IWD - News) and iShares Morningstar Large Value (NYSEArca: JKF - News) paid around 4%.
The problem at that time was that nobody was interested in yield. Investors shunned stocks and yields like cats shun water. Within a week of prices bottoming and stocks beginning to rally, the ETF Profit Strategy Newsletter recommended to load up on dividend-rich ETFs.
Here's the newsletter's March 2, 2009 recommendation: 'This counter trend rally will have to be broad and powerful in order to relieve investor's pent-up urge to buy. Dividend ETFs with a higher allocation to financials are likely to rise higher than the broad market. Some of the dividend yields are quite juicy and can help to offset timing mistakes.'
Beware of the Yields Trap
Since then, the S&P (SNP: ^GSPC) has risen more than 85%, the performance for the Dow Jones (DJI: ^DJI) and Nasdaq (Nasdaq: ^IXIC) has been similar. What about dividend yields?
If the March 2009 lows marked a true market bottom, dividend payments should have increased somewhat proportionally to stock prices. They didn't. In fact, yields today are lower than they were at the March 2009 bottom.
In March 2009 the dividend yield for S&P 500 constituents was 3.6%. By multiplying 3.6% with the March 2009 low of 666 we arrive at a dividend yield of 23.98 points. In October 2010, the S&P yielded 1.97%. Based on an S&P at 1,200 points, this represented 23.64 points, 0.34 points less than at the March 2009 bottom.
It's hard to imagine that dividends today are less than at the March 2009 bottom, but that's reality and not the sign of a healthy market. Hunting after yield without considering the risk at current prices is similar to maxing out your credit cards just to rack up frequent flier miles. The return comes at a (long-term) cost.
Beware of the Earnings Trap
In my humble opinion, earnings are more than just a trap, they are a minefield. According to the numbers we are fed, earnings have already surpassed the threshold reached at the peak of the dot-com bubble and are projected to eclipse even the 2007 all-time record high in 2011.
If this doesn't strike you as odd, take a moment to examine the chart below. Leading up to the 2007 stock market and earnings high, we had consistent GDP growth (not historically great but steady). The real unemployment rate (U-6, published by the Bureau of Labor Statistics) was 8.4%.
Today, GDP is sputtering (and inflated by government subsidies) and U-6 unemployment has more than doubled to 17%. For those who prefer to go by the media's more palatable U-3 jobless number, it has soared from below 4.7% to 9.6%. Does that look like the kind of environment that would produce record high earnings?
I don't think it would be presumptuous to wonder if financial engineering and massaging the books has something to do with high earnings. Remember the 157 rule change which allows banks (NYSEArca: KBE - News) to hide real estate losses (see June 2010 ETF Profit Strategy Newsletter for a detailed analysis).
Even when assuming that current earnings are for real, the P/E ratio (high earnings translate into a lower P/E ratio) is still historically elevated. Admittedly not as much out of line as a year ago, but still high.
Don't Bet Against Valuations
Buying into an overvalued market and expecting a long-term gain, is like sowing seed in the winter and expecting to reap in the summer - it doesn't work that way.
Of course, over the short-term, markets can defy valuations and make disciplined investors look like temporary fools. But, as the 2000 and 2008 declines have shown, there are no shortcuts to long-term success.
The most intriguing facet of dividend yields and P/E ratios is that they tend to pinpoint major market bottoms. All historic market bottoms had one thing in common: super high dividend yields and ridiculously low P/E ratios.
Based on this historic clue, the March 2009 bottom looks more like a fake than a major bottom. Just as ice doesn't thaw unless the temperature rises above 32 degrees, the market doesn't bottom until P/E ratios and dividend yields signal that a valuation reset has occurred.
The December issue of the ETF Profit Strategy Newsletter includes a detailed analysis of P/E ratios, dividend yields, mutual fund levels and the Dow measured in gold. P/E ratios, dividend yields and the Gold Dow are plotted against the S&P 500 in order to ascertain a target range for an ultimate market bottom based on historical precedence.
A picture paints more than a thousand words, and the featured charts show that the March 2009 lows did not constitute a historical low or valuation reset. Valuation metrics indicate that a return to the mean should eventually retrace recent gains.
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