Dividends: Make the Long-term Commitment

Josh Peters: Good to be here, Jeremy.

Glaser: We've seen some pretty remarkable stock market gains over the last few years, particularly against that backdrop of pretty slow earnings growth. I know you've taken a look at where valuations are today versus historical levels. Can you tell us where you think the market is right now?

Peters: I wish I had a more inspiring answer, but honestly, I think we're looking at a fairly valued market here. And I look at it a couple of different ways. First, I always like to check in on what Morningstar's fair value estimates indicate. The median stock that we cover right now is 4%-5% overvalued, which, it has the O for overvalued in it, but we're kind of talking margin of error. That's not a big gap that would really make you concerned about the level of market prices today.

I also went back and looked at some P/E data. And looking at the price/earnings ratio for the S&P 500 using the operating earnings per share--that is the market's convention for better or worse--the market right now has been trading at about 17 times trailing earnings per share. That is a lot higher than the 13 that we were at, at the end of 2011, or even the 12 multiple that we had at the third quarter of 2011. And a lot of people are saying, "Stocks are up more than 40% in less than two years. What happened?"

Well, earnings haven't grown that fast but the P/E has gone back to essentially normal. About 17, 18 times is the median trailing P/E multiple of the S&P 500 index, going back to 1988, 1989. Yes, we didn't have a lot of earnings growth, but stocks were, frankly, very cheap in 2011 now especially when viewed by hindsight.

Glaser: What about some other metrics like the Shiller P/E that's trying to look at more normalized trailing earnings and maybe get rid of some of the noise we've seen over the last few years? That shows the market looking a little bit more expensive. Do you think that maybe looking at trailing earnings of operating income just isn't the right way to think about the market right now?

Peters: Well, I like these alternative metrics, and I have been watching the Shiller P/E for a long time. Being Robert Shiller, a new Nobel laureate, author of Irrational Exuberance, and called the dot-com bubble. And he's got this approach that averages earnings during the preceding 10 years, trying to strip out some of those, say, recession or top-of-the-cycle type of factors adjusted for inflation, so that it includes some measure of growth. On that basis, the market does look really overvalued, more like 25 times this average earnings figure on a decade-trailing basis.

But two, if you are going to compare apples to apples, that's a similar type of number what we've had here over the last 20 to 25 years. And when Shiller put together his thesis, he started looking at data going all the way back into the 19th century to make an assessment about what the normal P/E is. My sense is that, while that history is very important and that some averaging will help you smooth out some of the cyclical factors in any one year's earnings, frankly I think the stock market has grown up and corporate America is able to support these higher valuations because companies on the whole have become more profitable over time.

So, with a 15% average return on equity over the last decade, the kind of valuation multiples that we're seeing right now actually do make sense. And I'm not sure that comparing the adjusted Shiller P/E today with an average that stretches back to the Great Depression and before that even, is necessarily the best reference. If you think about it intuitively as companies become more profitable, generating higher returns on capital, then those P/E multiples should be higher just like they would be for individual stocks.

Glaser: But are we likely to see some of that profitability get squeezed or kind of get closer, some reversion to the mean, due to new competition over time? Do you expect that profitability to remain at these higher levels?

Peters: I keep coming back to the question of what is going to force profit margins lower, and this is a question that's gotten a lot of attention. We're at corporate profits here at a record share of gross domestic product, which seems like something that can't be sustained. In the past, corporate profits and corporate margins have tended to be mean-reverting. But honestly, you have to have some force that would move corporate profitability back to the mean, and I just can't see any of the pressures out there.

I think that this reflects the fact that companies have a lot more political clout, especially relative to labor than they've had in the past, for companies to capture a larger share of economic activity in the form of profits. Unless we see some major, major changes on the political front, that I really don't see as happening anytime soon in sort of the stalemated political state that we're in right now, then these earnings probably are sustainable.

Glaser: If the market does look fairly valued to you right now, what does that mean for returns? Should investors expect a smooth ride up from here?

Peters: Well, I wouldn't call it smooth. It's been more than two years now since we had even a 10% pullback in the S&P 500; that's unusual. Even for a long-term investor you have to anticipate that there's going to be some significant ups and downs along the way. But to me, a fairly valued market is one that will give you a fair return over a long period of time. So I'd call that anywhere between 8% and 10% if we're looking out 10, 20 years, 8%-10% a year.

So the biggest question becomes not, "Do I wait and try to get in the stock market cheaper, or are we going to have a melt-up and the stock market becomes hugely overvalued?" Instead, I think you just say, if the market overall is fairly valued and you can earn a fair return, what can you do to reduce your risk? Owning higher-quality companies, companies with narrow and wide economic moats, clean balance sheets, below-average cyclical risks to their revenues and cash flows, those are all advantages. Owning high-yielding stocks, I think, is a huge advantage. It takes a lot of pressure off the investor to get a lot of growth and earn a lot of capital gains, because you have this nice base of dividend income.

But perhaps more importantly than anything, if you're in a fairly valued market you have to be prepared to make a long-term commitment. You are not trying to buy low and sell high, which is extremely hard to do in the first place. Instead, you want to make sure that you've got both the personal financial capacity and the psychological capacity to ride through those future corrections and future recessions so that you have the opportunity to get that long-run average return that I think is still quite attractive relative to the alternatives of bonds and cash.

Glaser: Josh, thanks so much for joining me today.

Peters: Thank you too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.