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Strategies & Market Trends : Graham and Doddsville -- Value Investing In The New Era -- Ignore unavailable to you. Want to Upgrade?

To: Freedom Fighter who wrote (426)	7/9/1998 4:16:00 PM
From: Axel Gunderson	Read Replies (2) \| Respond to of 1722

The long term real rate of return on stocks is 7%. In today's market, measured on a peak to peak basis, earnings for the S&P500 grew at 6.3% in the present cycle. The current dividend yield is about 1.5%. If profit growth stays the same and PE's stay the same, the long term return from stocks will be 7.8%. (6.3 + 1.5) The 10 year inflation expectation is currently 1.8%. This means that stocks are priced to give a 6% real rate of return "under these assumptions". ...I also find it interesting that Alan Greenspan has often talked about historical relationships and lower than usual risk premiums....The rate of return must be greater than the risk premium average in recent times. Wayne, I agree with you that the market is overpriced. But something is missing in the above - the relative attractiveness of competing asset classes. Since the beginning of 1970, the differential between the implied return (6.3% growth + dividend yield) and the long bond yield has averaged 1.85%. As of the close Friday it was at 2.10%, i.e. 6.3% (growth) + 1.4% (dividend yield) - 5.6% (long bond yield) = 2.10% Yesterday the S&P 500 hit a record for trailing PE. You believe, and I believe, that this is not sustainable going forward. But from the standpoint of an automaton looking at the options, there is little incentive to change asset classes. As an interesting aside, the lower the dividend yield (and the more overvalued the market?) the lower the apparent hurdle for enterprising investors. Assume an investor who faces combined federal and state taxes of 33% on dividends, and 25% on long term capital gains. If the market is priced to give a dividend yield of 3.8% (average since start of 1970) then the implied after tax return of the market is 8.85%. To beat that with long term capital gains on non-dividend paying stocks requires a gross return of 11.06% - a hurdle 2.21% better than the market. With today's 1.4% dividend yield, the implied return is 7.7% and the enterprising investor could match it with long term capital gains on non-dividend paying stocks that gross 9.05%. That is a hurdle of only 1.81% better than the market. Now I doubt many investors think explicitly in such terms. But it is interesting to see how such "irrational" investing can be seen to be "rational" in some mathematical sense. Axel