By Merle Yoder
Declines in prices of financial assets occur regularly. Some of the declines are epic. They trace a destructive path. The media report that declines are inherently unpredictable. Should we ignore painful episodes such as the current one? Or, with astute analysis prepare ourselves to take advantage of declining asset prices? Highly credentialed analysts from varied disciplines predict epic declines and often accurately describe how the declines will unfold. The late Martin Feldstein wrote three articles (WSJ and NYT) that predicted the current episode of decline.
The analysts, the experts frequently focus on the financial and normative characteristics of the market, e. g., price earnings ratios, the amount of and location of leverage, the concentration of nominal wealth in favored assets (Big Names), the appearance of speculation (SPAC’s, cryptocurrency).
There is a simple method to measure risk though on a small data sample, the modern era 1926 to the current date. The datum is the dividend yield on the dominant average, the S&P 500. When the dividend yield declines to 2% and less, the amber light of caution flashes. When the dividend yield approaches 1%, the red light of danger flashes crimson.
Why does that light flash crimson? Because the data show that the return on equities is almost entirely income and the compounding of that income. The logic is that when there is almost no income, there is close to zero “return.” Is not the rising price, i.e., the growth, a return? The data show that in recent years the rising price “return” dwarfs, renders insignificant the cash income return.
Let’s clarify what return is and what it is not.
Joe purchases equity X at $25. Twelve months later X is $30. Joe’s 12 month total return is 20%. Wrong! Erroneous vocabulary. Absent a dividend there is zero return.
Joe sells the equity X at $30. Now the TR is 20 percent absent income taxes. Wrong! Erroneous vocabulary. There is no return. There is a transaction. Joe has sold X to Jill. She paid $30 in cash and holds X, the very same shares previously owned by Joe. By definition no return occurred. Joe profited from Jill’s decision to purchase X. X itself returned nothing to Joe.
Definitions and precise use of words are important. Here are some common abuses of precise definitions.
1. Common stocks are “investments.” (No, they are money denominated financial assets.), 2. Entities “invest” in common stocks to “make money.” (No, entities buy common stocks because they have money.) 3. Common stocks have the ability to “make money.” (No, only money makes money.), 4. 1 – 4, enables 5. Many common stocks are “liquid.” “Liquid” means easily buyable and salable. They are “money good.” (No, as Henry Kaufman wrote in a monograph from Solomon Brothers years ago, the only liquid asset is cash, i.e., money.).
The weak logic in 1 – 5 and unsustainable price increases allow the S&P 500 dividend yield to decline to insignificance. The insignificant dividend yield is temporary because the yield will eventually rise to 3% to 4%, what we believe is its natural state. To reach its natural state the S&P 500 should encounter little resistance by declining 50 percent from current levels.
The common denominator of the financial markets is money. Money may become “hot,” full of energy. The energy inflates market prices unsustained by long term value. Such unsustainable increases fuel employment growth in the financial industry amid shortages of real life necessities.
Conditions for the epic decline are propitious. Money’s temperature fluctuates. The cooling period has commenced.
By Merle Yoder, Greenwich Investment Management
MY@GreenwichInvestmentMgt.com
No content published here constitutes a recommendation of any particular investment, security, a portfolio of securities, transaction or investment strategy. To the extent any of the content published may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Consult your advisor about what is best for you.
