Computerized Investing - Spreadsheet Collection/Spreadsheet Collection.iso/pc/ibm9/mrk40-95.doc

Text File | 1995-10-04 | 13.4 KB | 299 lines

MRK40-95.XLS is an Excel 5.0+ workbook which contains monthly market data
covering 1940 through 1995 along with a series of charts used in the article
below. The worksheets included in the workbook are:
    MRK40-95 (Main data sheet with monthly data since 1940)
    S&P 500
    S&P 500 (Semi-Log)
    S&P Yield & Index (1946+)
    S&P Yield & Index (1960+)
    S&P PE Ratio & Index (1946+)
    S&P PE Ratio & Index (1960+)
    Yields & Inflation
    S&P & Bond Yields

MRK40-95.WK1 is a Lotus 1-2-3 2.0+ worksheet which contains the same monthly
data as in MRK40-95.XLS, without the charts.

Taking Stock of the Market: How to Evaluate Current Market Levels

Human emotions are the demise of many investors. It is
easy to get swept up in the euphoria of a bull market and
then to buy near the top. Conversely, all too often the
pessimism of a bear market causes an investor to head
for the sidelines exactly when more money should be
committed to the market. While no investor really knows
if the market has reached its top or bottom until well after
the fact, a historical perspective provides some
indication of what market levels are usual and what levels
are unusual. Markets rarely stay at historical extremes; it
is more likely that the market will move towards its
normal level rather than head for even higher extremes.
However, the speed of this adjustment is far from certain.
While it is possible to study the level of the market
directly, direct observation rarely provides much insight.
It is more practical and revealing to examine relative
fundamental values such as the marketís price-earnings
ratio and dividend yield.

Dividend Yield

The dividend yield is the indicated annual cash
dividend (most recent quarterly dividend times four)
divided by the current price. For individual stocks the
dividend yield is found daily in newspapers such as the
Wall Street Journal; for market indicators such as the Dow
Jones averages and Standard & Poorís indexes, dividend
yield is found in Investorís Business Daily and Barronís.
Higher dividend yields indicate that dividends are high
relative to the stockís market price; in general, this is an
indication of undervaluation. Lower dividend yields are a
sign of overvaluation, since the dividends are low relative
to the market price.

Historically, dividends have been important in market
analysis because they represent direct cash flows to
investors and cannot be manipulated by accounting
techniques, as can earnings and book value. Dividends
also tend to be more stable than earnings: Firms are
reluctant to raise the cash dividend until they are certain
that earnings and cash flow levels will be sufficient to
cover the new dividend level, even if earnings vary, and
firms rarely decrease dividends unless financially
pressed. For market composites, such as the S&P 500, the
dividend may occasionally decline, but the decreases are
small.

Prices, on the other hand, vary considerably. When
prices rise faster than dividends, the dividend yield falls
and the market approaches an overvalued position.
Conversely, when prices decline, dividend yields rise
and stocks move toward an undervalued position. The
difficulty lies in determining when the yield is
approaching an extreme position.

An additional comparison can be made of the dividend
yield versus other yields. For instance, if the dividend
yield on common stocks is falling relative to the yield on
bonds, bonds become more attractive and money moves
out of stocks and into bonds and money funds.

A graphical illustration of the historical dividend yield
helps to highlight market extremes. Figure 1 (S&P Yield & Index (1960+))
displays the monthly dividend yield of the S&P 500 along with
the S&P 500 index value since 1960. The S&P 500ówhich
includes large capitalization industrial, transportation, utility, and
financial stockóis displayed as the light gray line using a
semi-log scale in which equal distances represent equal
percentage changes throughout the chart.

The dividend yield appears to bump against invisible
barriers, but the range changes over time. In the 1960s
and early 1970s, dividend yields below 3.0% coincided
with market tops. Market bottoms roughly coincided with
yields above 3.7%, but the market bottom yield marker
steadily rose over that time period, matching the general
increases in interest rates. The severity of the 1973-1974
bear market is highlighted by the increase in dividend
yields to nearly 6%.

Six percent seems to mark the high range through the
1970s and early 1980s. Notably, the market bottomed out
in August of 1982, with dividend yields going above 6%.
The yield dropped steeply through the bull market until
it broke the 3% level in 1987 just before the market crash
in October. The yield returned to its long-term average of
3.7% during the correction. Recently, the yield has
trended down to 2Ω%, which would normally represent a
red flag. However, before you move your portfolio into
cash, an examination of other valuation measures is
appropriate.

Price-Earnings Ratios

The price-earnings ratio also provides valuable insight
into market levels.  The price-earnings ratio is the current
price of a stock or value of an index, divided by annual
earnings. The price-earnings ratio for the Dow Jones
industrials can be found in Investorís Business Daily, and
ratios for a range of market indicators can be found in
Barron's.

Like the dividend yield, the price-earnings ratio is
driven by stock prices, although earnings change more
quickly than dividends, responding to changing business
conditions. In theory, the market is fairly valued when
stock prices reflect reasonable expectations regarding
future earnings growth. When prices rise faster than
earnings, resulting in higher price-earnings ratios, the
market is predicting significant future earnings
increases--a prediction that may be overly optimistic. As
price-earnings ratios approach historic lows, markets have
usually undervalued future earnings growth, overreacting
to a weak market environment.

The price-earnings ratio for the S&P 500 along with the
index value is displayed in Figure 2.(S&P PE Ratio & Index (1960+))
A range of extreme values also seems apparent. Generally,
levels above 20 serve as warnings for market tops. However,
the relationship gave a false warning in 1991. The severe
increase in the price-earnings ratio from under 14 to over
26 coincides with the last recession that officially began in
July of 1990 and bottomed out in March 1991. Normally,
the price-earnings ratio is calculated by dividing price by
earnings over the last 12 months. Short-term decreases in
earnings due to events such as special charges,
extraordinary events, or in some cases, even recessions
may lead to unusually high price-earnings ratios. As long
as the market interprets the earnings decrease as
temporary, the high price-earnings ratio will be
supported. The price-earnings ratio dropped as earnings
rebounded after the recession, while the market was able
to post even further gains.

A price-earnings ratio near 7 served as a buy signal
during the 1970s and early 1980s. The bear-bull reversals
in 1974 and 1982 stand out as clear examples. The price-
earnings ratio has averaged 15.1 since the 1960s, and
recently the ratio has been bouncing between 16 and 17,
above the long-term average, but not at the extreme level
of the dividend yield.

Valuing the Market

Charts provide a feel for whether or not the markets
currently are at a reasonable level. Valuation models help
to actually estimate the appropriate level of the market
based upon historical relationships. While valuation
formulas can be made as intricate and as complex as
desired, all formulas are derived basically from the
capitalization approach of transforming a future stream
of income into an equivalent principal amount. The
success of the valuation depends upon using
expectations that are accurate and well-founded.
A basic valuation approach for valuing the market using
dividends divides the expected dividend by the
capitalization rate. The capitalization rate for dividends is
simply the required dividend yield. The higher the
required yield, the lower the valuation.

Table 1 (Below) presents the valuation of the market using the
average dividend yield, as well as high and low yields, as
the capitalization rate. The current indicated dividend of
the S&P 500 is $13.94 (adjusted to the index points) and
was obtained from the S&P's Outlook publication.
Dividing the indicated dividend of $13.94 by the average
dividend yield of 3.7% (0.037 in decimal form) leads to a
valuation of 377--well below the current S&P 500 level of
582. If we assume that the long-term average yield is a
reasonable required dividend yield, then the market is
strongly overvalued. Either the dividend payouts must
increase or stock prices decrease to raise the yield. Using
the historic low and high dividend yields as capitalization
rates helps to indicate the extremes that the market
might be expected to experience based upon past
observations.

Table 1.
Basic Market Valuations

Dividend Valuations
  Equation: Dividend / Yield = Market Value

Using indicated dividend and

  Low dividend yield (7/95):      $13.94  /       0.025   =       558

  Average dividend yield:         $13.94  /       0.037   =       377

  High dividend yield (6/82):     $13.94  /       0.064   =       218

Using projected dividend and

  Low dividend yield (7/95):      $14.50  /       0.025   =       580

  Average dividend yield:         $14.50  /       0.037   =       392

  High dividend yield (6/82):     $13.94  /       0.064   =       218

Price-Earnings Ratio Valuations
  Equation: Earnings x P/E Ratio = Market Value

Using latest 12 month's earnings and

  High P/E ratio (7/92):        $34.62  x       26.2    =       907

  Average P/E ratio:            $34.62  x       15.1    =       523

  Low P/E ratio (3/80):         $34.62  x       6.9     =       239

Using projected earnings and

  High P/E ratio (7/92):        $37.84  x       26.2    =       991

  Average P/E ratio:            $37.84  x       15.1    =       571

  Low P/E ratio (3/80):         $37.84  x       6.9     =       261


Current S&P 500 Index Value:    582


The equivalent valuation technique using earnings is to
multiply the expected earnings per share by the price-
earnings ratio. When greater risk and uncertainty in
company and market prospects are perceived, price-
earnings ratios contract and consequently, valuations
decline as investors are only willing to pay a smaller
amount for a given level of earnings. Table 1 also
provides valuations of the market using the average
price-earnings ratio as well as low and high price-earnings
ratios. The current trailing 12 months' earnings of $34.62
was also obtained from the S&P's Outlook. Multiplying
the trailing earnings by the average price-earnings ratio of
15.1 leads to a valuation of 523--still below the current
market level of 582 but much higher than the comparable
dividend valuation. The historical range of price-earnings
ratios leads to a high valuation of 907 and a low valuation
of 239.

Valuations should be based upon the reasonable
expectations of projected dividends and earnings. Table
1 repeats the valuations using dividends and earnings
forecasted for next year. The projected dividend rate of
$14.50 was calculated using the recent market dividend
growth rate of 4% [$13.94 / (1 + 0.04)]. Based upon the
projected dividend and the average yield, the valuation
is still well below the current market level.

The valuation based upon the expected earnings and
price-earnings ratio paints a different picture. Using the
expected 1995 earnings of $37.84 from the S&P Outlook
and the average price-earnings ratio leads to a valuation
of 571óslightly below, but near, the current 582 market
level, indicating that the market is fairly valued.

The difficult question to answer is: Which model is
right? Has the market changed fundamentally since 1960
leading to a revised expected dividend yield? Some
analysts believe that firms are using excess cash to
repurchase shares or reinvest in other businesses rather
than expose their shareholders to double taxation. The
composition of the index has also changed over time. The
industrial segment of market indicators are composed of
a higher percentage of lower-dividend-paying service
firms than was the case in the 1960s. Historical dividend
yields may not be useful guides for current valuations.
Earnings and cash flow models may now be more
appropriate than dividend models in valuing the market.

Tying current valuations to historical relationships is
always difficult. Markets are dynamic and the market is
made up of a changing mix of individual stocks. With tax
laws and corporate strategies changing, rigid, historically
based valuations can prove misleading without a
subjective evaluation of the reality of dividend and
earnings expectations.

(C) 1995 by the American Association of Individual Investors