Stocks: A Bear Case by Felix Salmon

If stocks fall, that means they're cheaper than they were. And if they've gotten cheaper, they must be a better investment, right? That's the gist of a blog entry from Jim Surowiecki today.

But that's not necessarily how this is going to play out. It's true that stocks have been a good long-term investment in the past, but that doesn't make them a good long-term investment in the future, even if they are looking cheap(ish) these days. And to understand why, it's worth looking at a very old-fashioned indicator: the stock market's dividend yield.

As Steve Waldman rightly points out, the vast majority of investors aren't speculators trying to maximize their net worth. Instead, they're trying to maintain their standard of living post-retirement:

Our current system does not serve savers well, because our markets offer inadequate ways of purchasing claims on future consumption (as opposed to claims on future production).

But for many decades, it was fair to assume that stock dividends, in aggregate, would rise more or less in line with the cost of living. When you bought a stock portfolio, you were buying a payments stream -- one which, you could be reasonably sure, would increase steadily over time. As such, some stock-market investors actually liked it when stocks went down, because that meant that buying future payments had just gotten cheaper, and you could buy more of them.

In the late '70s and early '80s, the S&P 500's dividend yield was over 5%, and it was not uncommon to find retirees living off their dividends. Even though the stock market was at depressed levels at the time, it had actually proved to be a perfectly good investment, because many shareholders cared only about the amount of their dividends, not the price of their stocks.

Then, however, things began to change. Stock prices started to rise much more quickly than dividends, making that future earnings stream much more expensive. And good stock market investments turned out to be not those which reliably paid a bit more in dividends than they had the previous year, but rather those which had increased the most in price. An entire stock-market sector -- tech stocks -- was created on the tacit understanding that most of them would pay no dividends at all, most of the time. And the most admired man in the stock market, Warren Buffett, also abjured dividends entirely.

In the mid-1990s, about the time that Alan Greenspan first started warning about "irrational exuberance", dividend yields dropped below 2% for the first time, and they stayed there even through the dot-com bust. People had long since stopped buying stocks for their dividends: Now, they were investing in the expectation of future capital gains.

A stock portfolio wasn't something you could live off, any more: The only way to do that would be to sell it down over time. Equities might still be permanent capital from a corporate-finance point of view, but from the point of view of an individual investor, they were bought only to be sold, at a higher level, in the future, to someone else.

This worked for a long time. As defined-contribution pension plans replaced defined-benefit schemes, and as a generalized unanimity emerged that stocks were the first best place to put retirement savings, the flow of money into the stock market was more than healthy enough to keep prices rising and to justify people's faith that they would continue to do so indefinitely.

But if stock prices start falling year after year, then it will become increasingly apparent that it's not reasonable to expect long-term capital gains. Yes, stock prices have generally risen over the long term. But for most of the decades in question, people never really expected them to do so.

There's a word for an asset class which everybody expects to continue to rise in perpetuity: a bubble. And although stocks are down a long way from their highs, the idea of stocks as something to buy today and sell for more money tomorrow is so deeply ingrained in the national psyche that a few months of market volatility is nowhere near enough to erase it.

So consider this possibility: that stocks will continue to fall until their dividend yield reverts to its long-term historical mean, somewhere around 3.5%. At that point, people will start buying them not for capital gains but for income, and I think it's reasonable to expect a stock-market floor at roughly that level. From then on in, both prices and dividends would be expected to rise at roughly the same pace as national GDP.

Of course, there would still be volatility. But that doesn't mean that there's likely to be "exceptional performance in the future," in Surowiecki's words. Indeed, stock-market performance might be downright mediocre. Which might not be such a bad thing.

Update: The wittily-named "Modigliani_Miller", in the comments, points out that in a world where investors prefer capital gains to dividend income (which is probably any world where the capital gains tax is lower than the income tax), companies can simply return money to shareholders through share buybacks rather than dividends.

On the other hand, there's also this, from dWj, which makes my case positively sunny:

There used to be a rule of thumb that stocks were expensive when the dividend yield got down to 3% and cheap when it got to 6%. By this measure, after 12 years, stocks are finally down to "expensive" again -- and will be cheap when they lose another half of their value, supposing the dividends aren't cut too badly. (I've been using $25 per S&P 500 lately when doing dividend calculations, which assumes dividends only drop about 15%. We'll see about that.)