Valuing the Market By Dividend Yield

When we try to value a stock or the entire market, we never want to look at just one method. Instead, we want to look at as many as we can because every method has some flaw.

Trying to value the S&P 500 by going by the dividend yield has been a surprisingly reliable indicator for the past few years and this is despite the historic movement of market interest rates. I especially like this method because dividends tend to be very stable (note the clear trends of the yellow line on the graph).

The graph below shows the S&P 500 in blue and it follows the left scale. The dividend is in yellow and it follows the right scale. The two axes are scaled at a ratio of 50-to-1 which means that the S&P 500’s dividend yield is exactly 2% whenever the lines cross.

I asked Larry Silverblatt, the brilliant analyst at S&P, what his projection for full-year dividends are and he said $26.33, so that’s the red line. That’s probably a very shrewd call because the trend of the red line seems perfectly consistent with where we’ve been.

Now here’s the chart that caught my attention — the dividend yield of the S&P 500 (in other words, the yellow line divided by the blue).

Except for the depths of the financial crisis, note how narrow the range is that the yield stayed in. Of course, you might say that that’s one hell of an exception. But still, once the worst of the financial crisis passed, the market’s dividend came right back to that 1.6% to 1.9% range.

The S&P 500’s dividend yield is currently 2.2%. Since 2003, the S&P 500’s dividend ranged between 1.6% and 1.9% more than 62% of the time. That’s pretty darn narrow. If Silverblatt’s forecast is correct and we use the 1.6% to 1.9% range, that implies a year-end target for the S&P 500 of 1,385 to 1,645.

The dividend yield chart is a good expression of “tail risk,” meaning what can happen when everything goes kablooey. Most of the time, things are by definition, normal. If we’re still in normal times, stocks are very cheap.

But to give you an example of how far things can go wrong, if the S&P 500’s dividend yield decides to match the peak yield from two-and-a-half years ago, punching in Silverblatt’s dividend estimate gives us a year-end S&P 500 of 646.

Posted by on August 22nd, 2011 at 2:02 pm


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.