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Is It Safe? Stocks: Pro, Con, and the Dividend Bubble

The U.S. stock market is at post-crash highs in the middle of domestic and world economies optimistically seen as struggling. Does it make sense? Is the market reasonably priced? Is it safe?

Well, it depends who you talk to:

Pro: The S&P 500 is currently about 16 times earnings on a 12-month trailing basis. This is about average on a historical basis (link). Additionally, we are in the recovery stage of the business cycle where earnings slowly improve. Furthermore, price/earnings multiples are inversely related to interest rates and interest rates are extraordinarily low. The average dividend alone on high-quality stocks is paying far more than what C.D.’s offer. Lastly, the charts are pointing up; as the saying goes, “the trend is your friend”.

Con: Shiller’s methodology for calculating the S&P 500’s price-earnings ratio is based on average inflation-adjusted earnings from the previous 10 years (link). It is currently at 23 times earnings with a historic average of about 17. The S&P 500’s current dividend is currently substantially below the historic average meaning prices are high (link). Additionally, corporate profits as a percent of GDP are not as high as some claim, but high none the less (link). Profits could decline as a percent of national income as wages start to reestablish themselves. Lastly, the end of borrowing the difference between what is spent and what is earned is here. Politicians call it ‘austerity’. It is inevitable and will depress economic activity.

The Dividend Bubble: The Federal Reserve’s Zero Interest Rate Policy (ZIRP) intervention has forced normally conservative savers into the stock market looking for yield. Dividend stock has been bid up distorting their price (a bubble). The resulting elevated P/E of these stocks has raised the overall multiple of the market. The other side of this is many other stocks remain at more traditional P/E multiples.

For example, a currently popular dividend stock is now priced at 18 times earnings and a 4.3% dividend yield. According to Valueline, its historical average P/E is 14x and its average dividend yield is 5.0%. This implies a ‘fair value’ of over 15% below its current price.

With the stock market at post-crash highs it may be a good time to do some math.