When Music Stops...So May the Market

04/26/2013 7:45 am EST

Focus: MARKETS

Kelley Wright

Managing Editor, Investment Quality Trends

The market is approaching overvaluation, but the outcome of the next cycle depends on the Fed’s actions, writes Kelley Wright of Investment Quality Trends.

Since the Dow Jones Industrial Average breached its previous high-water mark on March 5, the vast majority of financial commentary has centered on price.

Price is not unimportant. It is, after all, how the vast majority keep score in the stock market. Where price fails as a metric, though, is that as a sole measure, it tells you nothing about value. “Price is what you pay. Value is what you get,” said Warren Buffett.

Nothing is more important than establishing value, both in individual stocks and the broad market. Just as we find areas of good value from dividend yield for individual stocks, we do the same for the Dow using its composite dividend.

Historically for the Dow, four specific areas of dividend yield have a repetitive pattern: 3% (Overvalue), 4%, 5%, and 6% (Undervalue).

Between 1929 and 1995, the Dow offered good value whenever the dividend yield rose to 6%, as it did in 1949 to 1953, 1974, and from 1978 to 1982. Strong price support also has been recorded at the 4% yield level, which halted and reversed declines in 1960, 1962, 1966, 1971, and most notably on October 19, 1987.

A 5% yield halted and reversed a major decline in 1970. More recently, the Dow came within ten basis points of the 5% yield level on an intraday basis on March 9, 2009.

With the exception of the period between 1995 and 2007, when the yield on the Dow declined to 3%, a Rising Trend has been reversed. This occurred in 1929, 1950, 1961, 1966, 1968, 1973, 1987, and 1990. As you can see, all four dividend yield areas have a significant history.

Currently we show 2% as the Overvalue dividend yield area. The reason for this is the Dow diverged from its long-term pattern between 1995 and 2007, where it fluctuated between 1.5% at Overvalue and 3% at Undervalue. It is our opinion that the Overvalue area for the Dow is adjusting—slowly—back to the 3% dividend yield area.

As we have written too many times to track, there is the stock market and there is the market of stocks, which are two entirely different things. We base this on having observed our market of stocks—the Select Blue Chips—over the course of the last 47 years. As a result of these observations, we have developed another cyclical indicator, which measures what is always most important—value.

Our Select Blue Chips are grouped into four distinct categories: Undervalued; Rising Trends; Overvalued; and Declining Trends. Twice each month, we calculate how many stocks are in each category and what percentage that number is of the total.

By tracking the movements between categories and comparing those movements against the highs and lows on the Dow, we have observed that when the percentage of stocks in the Undervalued category rises between 70% and 80% of the total, it has coincided with a low cycle in the Dow.

In contrast, when the percentage of stocks in the Undervalued category declines to 17% or less, it has coincided with a high cycle in the Dow.

You will note that the Undervalued category has declined to 16.1% of our universe, which suggests that values are sparse. How long current Fed policy keeps the music playing is anyone’s guess.

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