Morningstar Advisor - February/March 2010 - 48

Morningstar Conversation long run. But it certainly messes with the price/ earnings ratios in ways that make the correlation with dividend yields disappear. If, on the other hand, you measure earnings yields on a normalized basis and compare them to dividends yields on a normalized basis, you actually get extremely strong correlations. GS: You see a secular decline in dividend yields, and that’s a phenomenon of the past 15 years. JH: But the accompanying phenomenon of the JH: Not on the basis of normalized earnings. The problem with 2007 was that profit margins in 2007 were about 50% above the historical norm, so they made observed price/ earnings ratios look quite attractive. But then, look what happened. What we observed in 2007 was a relatively rich earnings multiple applied to profit margins that were 50% outside the norm. past 15 years is that stocks have delivered bupkis. The reason we have not achieved any meaningful return in stocks is precisely because valuations have been enormously rich, and low dividend yields and high-normalized price/earnings ratios have been an extremely good signal about the prospective long-term returns on stocks. You could have observed that back in the late 1990s, when on the basis of any reasonable historical expectation for long-term earnings growth, and any reasonable terminal price/earnings ratio, stocks were priced to deliver returns well under the risk-free Treasury bill rate, which, in fact, they have. GS: That was a time period dependent in the So, it is true that we didn’t have the kind of extremes that we saw in 2000, but that was driven by the aberration in profit margins, which have been quickly normalizing during the recent downturn and, without the benefit of resumed leverage, are unlikely to go back to their 2007 peak. GS: The issue is whether or not this leads to extra volatility in the stock market. We haven’t seen a significant change in volatility in the stock market as yields have gotten to this low level. We went through historically low periods of volatility in the mid-1960s as yields collapsed and through historically low periods of volatility before this particular collapse. We’ve had extremely high periods of volatility in the 1970s at the same time dividend yields were high. JH: In the 1970s, yes, we had extremely high Now, by the way, between the 1974 crash and 1982, when dividend yields on the S&P 500 shot up to about 6.7%, it is very true—that by the end of 1982, you had an enormously good long-term buying opportunity for stocks. Even if you were to observe no change in stock valuations over the future, if you were to just have dividends growth at the same longterm rate as earnings, which is about 6.25%, you were priced to achieve long-term returns near 13%. So, yes, by the time that you got extremely high dividend yields, you had gone through an enormous amount of pain, and that was amply rewarded over the next two decades. But to say that low dividend yields don’t mean trouble ultimately is counter to the historical evidence. GS: No, I’m not trying to predict returns. I’m talking about volatility that you experience. JH: Low dividend yields have to be associated latter part of the 1990s, but it wasn’t true in the early part of the 1990s, and it wasn’t true in 2007 either. JH: It wasn’t true in the early part of the with higher volatility over time—at least if you measure the amount of loss that you end up achieving. Downside volatility in particular is horrific after periods of rich valuations, which are also characterized by low dividend yields. If you look at the historical record, it’s very hard to controvert that. GS: We have low dividend yields right now. JH: Which I’m worried about. GS: And I feel very comfortable with. 1990s, though, because we were about to embark on a decade that took stocks from a well-below-average multiple to a price-to-normalized-earnings multiple of about 34, where previously every bull market had topped out at about 19 or 20 times normalized earnings. It wasn’t true in the decade of the 1990s, but that was because the decade of the 1990s was the precursor for horrifyingly poor returns and experiences for the average investor. GS: Well, it doesn’t hold up with 2007— volatility and dividend yields were high. Why were dividend yields high? Because stock prices had collapsed and because dividend yields were previously extraordinarily low. So, yes, by the end of that decline, it is very correct that we saw high dividend yields and high volatility. But that high volatility was generated by the fact that stocks lost half of their value in 1972–74. GS: The market actually recovered in 1975. A Wager RL: Where do the both of you see relative valuations right now? GS: A lot of people have asked, what’s It was as high as it was in 1968. The demise of stocks in the 1970s is greatly exaggerated. The market went virtually straight up— 204%—from the end of 1974 through 1980. JH: And then by 1982, it had settled back. that year was a horrifying experience, and the P/E ratios were about 16, 17 times … the equity risk premium looking forward? Is it zero? Is it negative? Is it small? Or is it the historic norm, with the historic norm being in the 5.5% to 6% range? I would say that, 48 Morningstar Advisor February/March 2010

Morningstar Advisor - February/March 2010

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