Australia’s dividend recession
In Five crucial facts the mainstream has ignored (23 April), I demonstrated that “Australian equities have entered an earnings depression – and the market has mispriced it … egregiously.” Earnings finance dividends; so what, in the midst of Australia's bogus boom (19 May), are this depression’s implications for payouts? In this article I substantiate five more crucial facts. Collectively, they describe Australia’s dividend recession. The bullish mainstream has mostly ignored them (infrequently and grudgingly, it concedes #3):
- The All Ordinaries Index’s current dividend ($204 in May) isn’t much higher than it was almost 50 years ago (adjusted for the Consumer Price Index (CPI), $159 in May 1974).
- Since the GFC, the Index’s dividend has never come close to rescaling its pre-GFC peak. Today it’s 40% below its CPI-adjusted all-time high of $345 in October 2008;
- Since January 2020, the Index’s dividend has fallen as much as one-third;
- Over the past year, dividends have sagged significantly and earnings have utterly collapsed; accordingly, the Index’s dividend payout ratio has skyrocketed to a previously-inconceivable height: more than 200%!
- Common sense and history agree: this ratio is unsustainable. If so, then it will subsequently fall.
Logically, this expectation implies some combination of two possibilities: first, the Index’s earnings will rise (in absolute terms or relative to dividends); second, its dividends will fall. Bulls are certain that earnings will soar. I agree that at some point they’ll rise, but I doubt that they’ll lift nearly as much or as quickly as the optimistic – indeed, irrationally exuberant – mainstream expects. From April to May, earnings zoomed 25% – the sharpest one-month rise since May 1991. Enthusiasts will surely exult; they’ll also overlook the crucial fact that April’s level of earnings was lower than at any time since August 1993, and that May’s remains the lowest since April 1994. The overconfident herd thus ignores or denies the stark reality: the Australian market’s capacity to pay sustainable dividends – as measured by its payout ratio – is presently considerably weaker than at any time in the past half-century.
What the Mainstream Apparently Believes …
Judging from the headlines, there’s no doubt: during the year to come, the dividends of ASX-listed companies will increase. According to The Australian Financial Review (“Dividends Are Only Getting Better,” 12 February), “companies are setting the scene for improved dividends when the August earnings season rolls around.” It conceded that “dividends are broadly lower than a year ago, with the 12-month forward dividend yield dropping to 3.5% from 4.2% at the start of 2020, according to [one global financial institution].”
Henceforth, however, things would be different. “Encouragingly,” as the AFR quoted the Chief Investment Officer at another funds manager, “we are not seeing [the same] cuts in dividends as we were six months ago. Companies are setting themselves up for a potential improvement in dividends in the second half of 2020-21 …” The article’s conclusion is much less emphatic than its headline, but the expectation is clearly upbeat: “companies are starting to give guidance again, and as that confidence builds, then comes the prospect of dividend improvements.”
Others are much more excited. According to one global investment bank, “a dividend supercycle may be coming to Australia.” As justification of this strong claim, it advanced the feeblest basis: “With many of the nation’s biggest companies ramping up payments to shareholders aid a vastly improved outlook for earnings … the consensus forecast of the total dividend for the year ahead had risen 7% as of last week … It’s the fastest pace ever recorded for a reporting month and the fastest pace for any month in the past two decades … This move heralds, in our view, the early stage of an Australian dividend supercycle” (see “Dividend ‘Supercycle’ on Cards Amid Recovery,” The Australian, 23 February). The Australian (“Expect a Solid Rebound in Dividend Payouts,” 9 February) added: “brokers believe total dividends could rise by about 30% compared to last year.” Moreover, they “expect the dividend yield for the wider market to recover back above … 4% … in the months ahead …” (see also “Dividend Yields Set to Bounce Higher,” The Australian Financial Review, 19 May).
“Corporate earnings are rapidly recovering to pre-COVID-19 levels,” The Australian erroneously asserted (“Bigger Dividends on Horizon,” 31 March), “so what about dividends? Based on the recovery in earnings, investors may be pleasantly surprised. COVID-19-weary investors are already enjoying something of a dividend bonanza …” The Australian (“Options for Investors as Bourse Nears Record High,” 9 April) babbled in a similar vein: “investors aren’t too worried [about the “relatively high 12-month forward price-earnings multiple … of 19, versus 18.5 when it peaked last year”] because expectations for earnings and dividends have been surging since September.” It cited an “equity strategist” at a global institution: “consensus estimates for dividend payout ratios are too low considering expectations of a much more rapid recovery in earnings …”
… and Why Investors Should Doubt It
Which do you believe: soft and undependable words or hard and reliable numbers?
The insuperable problem for bulls is that a comprehensive body of rigorous academic research, extending over more than 50 years and a wide variety of countries, has almost invariably demonstrated that “consensus estimates” typically are irrationally exuberant rubbish.
The various editions of David Dreman’s book, Contrarian Investment Strategies, summarise this voluminous body of research. Its most recent (2011) compared analysts’ and economists’ consensus estimates of the S&P 500 Index’s prospective earnings – which, remember, finance dividends – to its actual earnings from 1988 to 2006. On p. 179 Dreman reported the results:
Economists … made earnings forecasts that were overoptimistic by an astounding 53% (over S&P reported earnings) annually on average over the nineteen-year period. Could anything be worse? Why, yes: analysts were overoptimistic by 81% annually on average over that time, an enormously high miss … Earnings forecasting is neither an art nor a science but a lethal financial virus.
These are average errors over the entire period; some years’ errors were even worse! Bearing that abysmal standard in mind, let’s put Dreman’s conclusion into a current Australian context. According to Standard & Poor’s, on 31 May the All Ordinaries Index’s actual (“trailing”) earnings were $113 and its PE ratio was 66. The current consensus forecast of the Index’s projected earnings is $394 and its projected PE is 18.8. “Analysts” are forecasting that during the next 12 months the Index’s earnings will skyrocket ($394 - $113) ÷ $113 = 249%! Let’s be extremely generous and arbitrarily assume that during the next year actual earnings increase 50% to $170. If so, then analysts’ forecast error will still be ($394 - $170) ÷ $170 = 132%. Even by their appallingly low standards, that’s a huge miss! Will the belated shock cause the market to regress towards a more rational PE?
Three key attributes characterise recent assertions about – and the mainstream media’s reportage of – the Australian market’s current and prospective dividends. First, they contain plenty of anecdotes, comforting words – sweetened with plenty of cherry-picking! – but no valid and reliable data. Second, they express fond hopes for the short-term future but provide no context from the long-term past.
Thirdly, and most importantly, their basis is demonstrably wrong: my article of 23 April – which, it’s vital to emphasise, analysed actual rather than “prospective” earnings – showed that earnings have plummeted rather than risen; similarly, in this article we’ll see that dividends have mostly been sagging rather than growing. The mainstream media’s coverage brings to mind a key passage in Robert Shiller’s book Irrational Exuberance (Princeton University Press, revised and expanded edition, 2015, p. xxvii):
… Unknown to most investors is the troubling lack of credibility in the quality of research being done on the stock market, to say nothing of the clarity and accuracy with which it is communicated to the public. Some of this so-called research often seems no more rigorous than the reading of tea leaves.
On p. xxviii, Shiller added:
Many individual investors think that institutional investors [“speculators” is probably a better descriptor] dominate the market and that these “smart money” investors have sophisticated models and superior knowledge to understand prices. Little do they know that most institutional investors are, by and large, equally clueless about the level of the market [and apparently in Australia, of its actual earnings, dividends, etc.]
The “expertise” of “smart money” is actually the overconfidence of speculators who aren’t nearly as intelligent as they think (see in particular Does high IQ make a better investor?). Journalists dutifully attribute to such people foresight which they don’t possess and authority which they don’t deserve. Let us therefore, in the spirit of dispassionate enquiry – and with a healthy dose of scepticism! – ignore them. Instead, let’s conduct our own analyses, let valid logic and reliable evidence guide us, and draw our own inferences and conclusions. It’s imperative that we do so:
Considered as a whole (in fairness, there are a few exceptions), so-called market experts apparently can’t or won’t think for themselves; what they seem to dread most is that you can and will. When that happens, you’ll experience an epiphany similar to Dorothy’s when Toto pulled the curtain: the “Wizard” of Oz was all show and no substance. Analysts, journalists and strategists certainly won’t think for you; hence reliance upon them often has been and remains dangerous to your wealth!
Fact #1: The All Ords’ Dividends Have Sunk One-Third since January 2020
Figure 1 plots annualised figures, calculated monthly, of the All Ordinaries Index’s dividend. This is the actual level of dividends paid during the past 12 months – not analysts’ “forward estimates” of payouts that will allegedly occur during the next year. On the eve of the Global Viral Crisis (GVC, January 2020), the Index closed at 7,121; its dividend yield was 3.84%; hence its dividend was 7,121 × 0.0384 = $273.
Figure 1: Dividend, All Ordinaries Index, Monthly Observations, January 2020-May 2021
By 2020’s full-year earnings season (August), dividends had fallen to $193, and by March 2021 they’d sagged a bit further ($187). The latest figure ($204 for May) is higher – but so were those in September and October before relapsing. Accordingly, from January 2020 to April 2021, the Index’s dividend decreased 32%.
Fact #2: This Decrease – and the Market’s Current Dividend Yield – Is Extreme but not Unprecedented
Figure 2a plots 12-month percentage changes of the Index’s dividends from January 1975 to March 2021. In January 1975, its dividend was $16.48; in January 1974, it was $15.11; hence during these 12 months it increased 9.1%. The average 12-month change is 6.6% and these changes are reasonably normally-distributed. Given their standard deviation (15.2%), ca. 95% of the observations lie ± two standard deviations from the mean, i.e., within the range -23.7% to 37.1%. Recent changes approach but remain within this range’s lower bound.
Figure 2a: Dividend, All Ordinaries Index, 12-Month Percentage Change (January 1974-May 2021)
The recent sharp fall of dividends is thus unusual but not unprecedented: during the recession of the early-1990s (12 months to September 1991) dividends fell 29%; they decreased almost as much (-26%) in the 12 months to July 1996; and during the GFC (12 months to October 2009) they sagged 31%.
Figure 2b plots the Index’s dividend yield since January 1974. A market’s yield expresses the dividends paid over the most recent 12 months as a percentage of its level at the end of that interval. In the 12 months to January 1974, for example, the Index’s dividend was $15.11 and at the end of that month its level was 328.5; hence its dividend yield was 15.11 ÷ 328.5 = 4.6%. Co-incidentally, its average yield to May 2021 is also 4.6%. After rising above 5% in March 2020, the yield fell below 3% in November and as low as 2.56% in April 2021; last month it was 2.76%.
This year’s yields are among the lowest in the series: only during the interval February-September 1987, which immediately preceded the Crash of 1987, was the yield still lower (2.2%). Of the ca. 550 months since January 1974, in other words, only in eight (1.4% of the total) was the dividend yield lower than it is today. The Index’s current yield is therefore extreme but not unprecedented.
Figure 2b: Dividend Yield, All Ordinaries Index (January 1974-May 2021)
Fact #3: Adjusted for CPI, the All Ords’ Dividend Is Now 40% Below Its Level on the Eve of the GFC
It’s easy to anticipate the mainstream’s response to Figures 1 and 2a-b. “COVID-19 is obviously to blame,” they’ll say. “But never mind: thanks to governments’ unprecedented and absolutely necessary fiscal and monetary stimulus, plus the rapid development and distribution of vaccines, the economy is quickly and strongly recovering – indeed, GDP has already surpassed its pre-pandemic peak. As a result, and like the economy, the All Ords’ dividends will also recover.”
It’s equally easy to cast considerable doubt upon this expectation. In a previous post to Livewire, I showed why “stimulus” is actually poison – and Figure 3 corroborates this claim. It plots the All Ords’ dividends in nominal and CPI-adjusted terms since their pre-GFC peak (which is also their all-time high) in October 2008. During that month, its CPI-adjusted dividend was $345. Then came the GFC – and huge amounts of so-called stimulus. It eventually lifted GDP above its pre-GFC level, but it didn’t restore the All Ords’ earnings and dividends. By March 2010, dividends had fallen to $199 – a decrease of 42% from October 2008. They then rose as high as $288 in August 2015, plateaued for the next five years and plunged during the GVC.
Figure 3: Dividend, All Ordinaries Index, Monthly Observations (October 2008-May 2021)
Adjusted for CPI, the All Ords’ dividends are now as low as they were at the GFC’s nadir. Indeed, their current level ($204 in May 2021) is 40% below its all time high ($345 in October 2008). On the eve of the GVC, dividends hadn’t come close to rescaling their pre-GFC peak; so is it plausible to assert and expect – as the mainstream does – that they will soon “recover” from the GVC?
Fact #4: Over the Past Half-Century, CPI-Adjusted Dividends Have Risen – but Are Now Well Below Trend
In January 1974 and adjusted for CPI, the All Ords’ dividend was $142 (Figure 4). As already stated, in May 2021 it was $204. That’s a compound rate of growth of ca. 0.75% per year. The dividends’ regression (trend) line has risen from $90 in January 1974 to $275 in May 2021: that’s a compound rate of growth of 2.7% per year. For roughly 30 years after 1974, the trend represented dividends’ actual course reasonably well. From the early-2000s until the eve of the GFC, however, dividends increasingly exceeded the trend; from ca. 2010 to the eve of the GVC they once again followed it – and since early-2020 they’ve sunk sharply below-trend.
Figure 4: Dividend, All Ordinaries Index, Monthly Observations (January 1974-May 2021)
A crucial question therefore arises: will dividends henceforth return to their 50-year trend – or have the GFC and GVC established a new trend?
For reasons that I’ll further justify below, I’m very sceptical that the All Ords’ dividends will soon recover from the GVC’s (never mind the GFC’s) hammerings. The key impediment, it seems to me, is the “earnings depression” that I documented on 23 April.
Fact #5: The Index’s Payout Ratio Recently Soared above 200%
No matter how closely you follow the financial news, this fifth fact will almost certainly stun you. Like S&P’s calculation of the All Ords’ PE ratio of 77 in March and 81 in April, it certainly caused me to do a double-take, re-check and recalculate the raw data! For an individual company as well as the market as a whole, the dividend payout ratio expresses current (that is, over the preceding year) dividends as a percentage of current earnings. Assume, for example, that at a given point in time the All Ordinaries Index’s dividends are $60 and that its earnings are $100. Its payout ratio is therefore $60 ÷ $100 = 60%. According to Investopedia, “the payout ratio is a key financial metric used to determine the sustainability of a … dividend payment program.” This is because
Companies are extremely reluctant to cut dividends since [reductions or suspensions] can drive [their stocks’] price down and reflect poorly on management’s abilities. If a company’s payout ratio is over 100%, it is returning more money to shareholders than it is earning and will probably be forced to lower the dividend or stop paying it altogether. That result is not inevitable, however. [Financially-sound] companies [can endure a bad year] without suspending payouts, and it is often in their interest to do so … Long-term trends in the payout ratio also matter. A steadily rising ratio could indicate a healthy, maturing business, but a spiking one could mean the dividend is heading into unsustainable territory.
Figure 5: Payout Ratio, All Ordinaries Index, Monthly Observations January 1974-May 2021
“Generally,” Investopedia concludes, “the higher the payout ratio, especially if it's over 100%, the more its sustainability is in question.” In January 1974, the All Ordinaries Index’s dividend (in nominal terms) was $15.11; its earnings were $32.85; hence its payout ratio was $15.11 ÷ $32.85 = 46%. Since January 1974, the ratio has averaged 61% (Figure 5). Extremely high ratios by pre-2020 standards, i.e., of 90% or more, occurred in September 1990-March 1991 (that is, during the recession of the early-1990s) and November 1999, but each was short-lived.
Payout ratios of 90%-100% are nothing compared to those prevailing since August 2020! In that month, when most of the companies comprising the Index reported their first pandemic-blighted results, it skyrocketed to a new (by a huge margin) all-time high (123%). Since then, month by month, it’s risen remorselessly – and in March of this year reached 206%! By then, the All Ords’ earnings had cratered to $91 and its dividend to $187. Its payout ratio was therefore $187.35 ÷ $91.12 = 2.056 = 206%. In April the ratio rose marginally (to 207%) and in May it fell (to 187%).
Collectively, the companies comprising the Index are presently paying dividends roughly twice as large as their earnings. How can they do that? By paying distributions not just out of current but also out of retained earnings from previous periods – that is, by diverting retained earnings from their usual purpose (such as investments that lower costs, maintain and increase output, etc.) towards payouts to shareholders. How long can that last? Clearly, and as a matter of both strict logic and common sense, a payout ratio considerably more than 200% is unsustainable.
The All Ords’ dividend payout ratio has soared to an unmatched – and hitherto-unimaginable – high. This isn’t merely because dividends have collapsed to a post-GFC low; it’s also because, as Alan Kohler stated last year, “the stockmarket has come nowhere near to correctly pricing for the earnings recession [which has now become a depression] now under way.”
Recent ratios’ size and trend are beyond astounding, and it’s hard to express how improbable – by the standard prevailing until early-2020 – they are. (Since August, I’ve sometimes wondered whether there’s been some mistake. The ratio’s standard deviation is 16%. April’s was therefore a mind-numbing 9.1 standard deviations above its long-term mean, i.e., (206 - 61) ÷ 16 = 9.1.
What does that mean in plain English? Table 1 provides some context (as a commenter noted, its counterpart in Five crucial facts the mainstream has ignored misstated several likelihoods, e.g., it expressed the likelihood ± 1 s.d. from the mean rather than 1 s.d above the mean, etc.) If, before the outbreak of COVID-19, you sought to estimate the probability that in March 2021 the All Ords’ payout ratio would lie 1 or 2 standard deviations above its mean, you would have concluded that such a thing was readily possible. A ratio of 3 standard deviations above its mean was very unlikely, and one 4 s.d. was extremely unlikely but not impossible. A ratio of 5 s.d. above its mean is getting close to most people’s conception of “practically impossible” – and 6 s.d above the mean – a probability of ca. 1 in 1 billion – surely does.
Table 1: Standard Deviations and Associated Probabilities
Implications #1-2: An Extremely Low Dividend Yield Today Implies a Higher One – AND a Lower Index – Tomorrow
Like the All Ordinaries Index’s PE ratio, so too its dividend yield: over time it tends to regress towards its long-term mean; and at a given point in time its level influences the Index’s subsequent (short-term and medium-term) rates of return. It’s hard to exaggerate this result’s importance. In research conducted in the 1980s and 1990s, Robert Shiller outlined it – and partly for this reason won the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. (It’s commonly but mistakenly known as “the Nobel Prize in Economics” – in order, presumably, to give the impression that economics is as prestigious as chemistry, literature, medicine, peace and physics.) On 14 October 2013, in its announcement of the winners of that year’s prize, the Royal Swedish Academy of Sciences stated:
If [stocks’ prices] are nearly impossible to predict over days or weeks, then shouldn’t they be even harder to predict over several years? The answer is no, as Robert Shiller discovered in the early 1980s. He found that stock prices fluctuate much more than corporate dividends, and that the ratio of [dividends to prices] tends [subsequently] to fall when it is high, and to increase when it is low.
Table 2 corroborates this relationship (for background and an explanation of the figures’ derivation, see Speculators are playing with fire; investors, don’t get burnt!). Three inferences are most important. First, the All Ords’ dividend yield is mean-regressing. The lower its level at any given point in time (column headed “Range”), the more it (a) tended to decrease during the previous 12 months and (b) tends to rise during the next 12 months. If the past since 1974 is prologue, then today’s extremely low dividend yield will subsequently lift. The second inference is rough but nonetheless reasonably clear: the lower is the current dividend yield, the lower will tend to be the Index’s subsequent average short-term (12 months hence) and medium-term (five years hence) return.
Table 2: All Ordinaries’ Dividend Yield and Subsequent Annualised Return, by Quintile, January 1974-May 2021
The third inference is a stronger version of the second: dividend yields below 3% have tended, on average since 1974, to produce short-term losses and poor medium-term results. Today’s very low dividend yield thus bodes ill for tomorrow’s returns. (Compare Table 2’s bottom row to its counterpart in my article on 23 April: in both instances the short-term prognosis is negative and the medium-term one is below-average.)
Implication #3: What Can the Past Half-Century Tell Us about the Future?
Over the past year, the All Ords’ dividends have sunk by as much as one-third; adjusted for CPI, today they’re 40% below their all-time maximum level on the eve of the GFC. When will Australia’s dividend recession end? If I’m brutally honest and appropriately humble, my wisest answer must be: “I don’t know – and nobody else does, either.” The second-wisest, it seems to me, is:
Financially, there’s little new under the sun. Hence investors worthy of the name take financial history seriously. Based upon a systematic examination of the ASX’s past (that is, an analysis of its longest, most valid and most reliable series of data), it’s reasonable to infer that during the next 12 months the All Ords’ dividend yield – as distinct from its level of dividends – will cease to sag and start to rise.
If it respects logic and evidence – that is, doesn’t just cherry-pick what it likes and ignore or denounce what it doesn’t! – this inference should chasten rather than hearten the mainstream. To understand why, let’s start with incontrovertible facts: on 31 March, the Index closed at 7,017, its dividend yield was 2.67% (the lowest since 1987) and its dividend over the previous 12 months was $187. According to Table 2, when the Index’s yield has fallen below 3%, during the next 12 months it rises, on average, 39.3%. The fact that the dividend’s yield rises doesn’t mean that its level rises, but let’s assume that it will. Indeed, for the sake of charity and simplicity, let’s assume that during the next year the All Ords’ dividend lifts 39.3%, i.e., $187 × 1.393 = $260 (versus $204 in May). The bulls will exult – and ignore the fact that this hardly constitutes a recovery: after all, it merely restores dividends to their level in April of last year – which was below their level in January 2020 ($273).
If dividends jump to $260, that’ll be the strongest since the late-1990s. That’s very unusual but not too difficult to envisage (recall Figure 2a). But we must also acknowledge what optimists apparently refuse to consider: the possibility that dividends henceforth stagnate or resume their droop. That possibility is hardly the optimists’ only concern.
Higher dividend yields typically also beget lower Index returns. Specifically, when its dividend yield falls below 3%, then during the next 12 months the Index has fallen, on average, 7.2%. Let’s therefore assume that it decreases to 7,017 × (1 – 0.072) = 6,512. Read that again: if past is prologue, then during the year to March 2022 the Index’s dividends will lift smartly – but its level will slump. Indeed, if it occurs this fall will be the biggest since 2011 (-11.4%).
Bulls’ problems don’t end there; they face two further difficulties. First, what about the Index’s payout ratio? If the current ratio (182%) is unsustainable, then it will fall. How far? Again, I don’t know. So let’s – arbitrarily – assume that by March 2022 it decreases to 150%. If so, earnings will rise to $260 ÷ 1.5 = $173. That’s an increase of 90% from the low ($91) in March. Is it feasible? I doubt it: it’s never happened before (50% is the record), but hasten to add that there’s a first time for many things, including PE ratios of 77 and 81, so who knows? Again, however, enthusiasts should temper their enthusiasm: earnings of $173 are not greatly higher than in August 2020 ($157), much lower than in July 2020 ($297) and less than half their level pre-COVID-19 (i.e., $355 in January 2020).
The mainstream’s ultimate problem is that, even under improbably optimistic assumptions, the Index’s earnings don’t lift within a bull’s roar (pardon the pun) of their pre-pandemic level. As I see it, that’s hardly a “recovery” of earnings! And in the longer term, it hardly augurs well for rising and sustainable dividends.
The market’s PE ratio under the foregoing assumptions gives the bulls a second major headache. If in March 2022 the Index has decreased to 6,512 and its earnings lift to $173, then its PE ratio will be 6,512 ÷ $173 = 37.6. That’s far lower than the nosebleed level (77 and 81) it scaled in March and April respectively (it sank to a mere 66 in May!) yet it’s still ca. 2.7 standard deviations above its historical average (14.2) and almost twice the all-time high that prevailed pre-COVID-19. But the PE, as I’ve demonstrated previously, also mean-reverts. If so, then in two years’ time – and even if earnings continue to rise smartly, which is possible but hardly certain, the Index will continue to fall.
Some Even More Fundamental Implications
The distinction might sound pedantic, but it’s actually crucial:
What I’m NOT doing is opining or pontificating about the All Ords’ dividend. Frankly, you shouldn’t give a toss about my – or anybody else’s! – idle opinion about this and related matters. Instead, I’m attempting, through dispassionate analysis, to uncover valid patterns and reliable generalisations.
Hence the first implication: although my opinion doesn’t matter, very large numbers of peoples’ patterns of behaviour do. By “patterns and generalisations,” I mean “the collective judgements of market participants over the past half-century: large and small investors, astute and idiotic speculators, all of them acting in their self-interest as they see it, buying and selling the 500 stocks that comprise the All Ordinaries Index.” By my experience, overconfident bulls and short-term speculators (who typically comprise much the same group) dismiss history – particularly when sober historical analyses contradict their exuberant expectations! “History looks backward,” they often sneer, “but markets look forward.”
Their problem is that, by discounting or ignoring the relevance of the past, enthusiasts and speculators exaggerate the uniqueness of the present; and by rejecting the perspective that historical context provides, they become sanguine about the future – and grossly exaggerate their ability to predict it. As a result, they eventually encounter “negative surprises.” Systematic analysis of the past can tell us whether we hold reasonable expectations about the future. What occurred yesterday doesn’t determine what will happen tomorrow; it does, however, constrain it – and thus suggests realistic possibilities about what might plausibly occur.
The second implication: consciously or not, those who dismiss historical generalisations are (unwittingly?) arrogant. In effect they say: “I need no instruction; our forebears, and their successes and mistakes, have nothing to teach me.” It’s not just ironic, it’s comic: they wish to know nothing about yesterday, yet they act as if they know much about tomorrow! Cautious and humble long-term investors, on the other hand, readily recognise history’s significance: examining the past allows them to discern (albeit very indistinctly) the future’s possibilities. Describing what’s occurred and making rough sense why, in other words, provides a rough-and-ready “theory” of what might subsequently happen, what’s likely, less likely, etc. James Grant, the editor of Grant’s Interest Rate Observer, expressed this point evocatively in 1996:
What we do is look for extremes in markets: very undervalued or overvalued [and we look to the past to ascertain what constitutes an extreme]. When you have a theory to work from, you avoid the problem that comes with stumbling around in the dark over chairs and night-stands. At least you can begin to visualize in the dark, which is where we all work. The future is always unlit. But with a body of theory, you can anticipate where the structures might lie. It allows you to step out of the way every once in a while.
Grant’s insight segues to the third implication: during Australia’s bogus boom, whether we’re talking about the All Ords’ earnings or its dividends, PE ratio, dividend yield or payout ratio, we encounter extremes. Moreover, they all point in the same direction: overvaluation. At the same time, however, whether you’re an investor or speculator, it’s vital to distinguish aggregate-level (market index) results from company-level results. I therefore reiterate a key passage in Five crucial facts the mainstream has ignored:
Table 2 doesn’t imply – and no analysis of financial history can reliably predict – that a bear market, crash, etc., is imminent. From my analysis you shouldn’t panic, sell your shares and head for the hills: even if an index comprising 500 companies is grossly overvalued, it’s likely that some shares’ prices will still be sensible. Regardless of whether you accept or reject my analysis, you should ignore the mainstream, conduct your own analyses and draw your own conclusions – or find an investment firm (I can think of one!) which has a successful long-term track record of doing so.
Finally, and I think most fundamentally, your reaction to this and my previous two articles may provide tell-tale signs whether you’re a short-term speculator or a long-term investor. “Understanding the difference between speculation and investing,” wrote Jason Zweig in The Wall Street Journal on 11 June, “is essential to avoiding reckless risk.” Speculation is a zero-sum game: one’s loss is another’s gain, and large costs of transactions ensure that most speculators eventually lose – some of them heavily and permanently. Investment, on the other hand, is positive-sum (“win-win”); hence most long-term investors eventually create and fructify wealth.
Perhaps that’s why, if you’re a speculator, these articles have probably caused you to feel anxious, downcast, and perhaps even angry – and thus likely to reject outright my reasoning, evidence and conclusion: after all, what I’m saying is neither what “experts” assert nor what you want to hear, and currently the odds are stacked against you even more heavily than usual. If you’re an investor, on the other hand, you’ll likely be open-minded and perhaps even relieved. That’s because investors welcome assessments that challenge the mainstream. When valuations are attractive, investors buy from pessimists; when they’re prohibitive – as they mostly are now – they sell to optimists. Today, therefore, they possess plenty of dry powder. As a conservative-contrarian investor, the possibility of much lower payout ratios, higher yields and lower markets buoys me; how about you?
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After concluding an academic career, Chris founded Leithner & Co. in 1999. He is also the author of The Bourgeois Manifesto: The Robinson Crusoe Ethic versus the Distemper of Our Times (2017); The Evil Princes of Martin Place: The Reserve Bank of...