New highs, new doubts

This week's Buttonwood column, aptly titled "To infinity, and beyond", reminds us that stocks don't always go up and for good reason.

A significant proportion of the return from equities in the second half of the 20th century came from a re-rating of shares; investors were willing to pay a higher multiple for profits. But re-rating cannot continue forever. Although ratings have fallen significantly since the heady days of 2000, that is in large part due to the remarkable strength of corporate profits, now close to a 40-year high relative to national output. If profits revert to the mean, that could act as a drag on stock market performance. And, as with Japan, investors do not have much in the way of income to fall back on; the dividend yield on the American market is just 1.7%.

If investors want a simple parallel with share prices, they need only turn to the American housing market. Back in 2005, Ben Bernanke, then an economic adviser to the president, was asked about the possibility of a decline in house prices on CNBC, a financial-television channel. He said, “We've never had a decline in housing prices on a nationwide basis. What I think is more likely is that house prices will slow, maybe stabilise.”

Lots of people took the same view and were willing to borrow (and lend) on a vast scale on the grounds that higher house prices would always bail them out. They are now counting their losses. Investors in equities should beware of over committing themselves on the basis of a similar belief. Just ask the Japanese.

Most people seem to forget that when Benjamin Graham wrote about stocks many years ago, it was a markedly different stock market where high dividends were the rule, not the exception to the rule.

While profits may remain high, Graham's "margin of safety" - where investors might weigh a stock's higher dividend payment along with increased stock market risk against a lower yielding, but much safer bond offering - has lost much of its relevance since dividend payments are just a fraction of what they used to be, dwarfed by share appreciation that has become a way of life for many on Wall Street and a few on Main Street.

Of course, over the last twenty years of easy money and asset inflation, investors have been conditioned to look past this reality.

To infinity, and beyond!

ooo

This week's cartoon: