Dividend Theory Suggests Caution

11/28/2013 8:00 am EST

Focus: STOCKS

Kelley Wright

Managing Editor, Investment Quality Trends

Our Dividend Yield Theory looks at blue chip stocks, which have the tendency to follow a repetitive pattern of moving from historic parameters of high yield to low yield, and then back to high yield. This marks levels of historic under and overvaluation, explains Kelley Wright, editor of IQ Trends.

This theory can also be applied to the Dow Jones Industrial Average (INDU), which has also displayed a long-term, repetitive tendency to fluctuate between high and low dividend yield extremes. Indeed, looking at broad market behavior, we've seen three signs of Overvalued conditions.

1) the percentage of Undervalued stocks falls to 17% or less;

2) the percentage of Overvalued stocks is greater than the percentage of Undervalued stocks;

3) the dividend yield of the Dow Jones Industrial Average declines to within 10% of its historically repetitive area of low yield.

When the above Overvalued conditions have occurred simultaneously, there is historical precedent, or a tendency for, a broad market decline sufficient to remove these conditions as areas of concern.

Stated in a less clinical way, when these three red flags have appeared at the same time in the past, the broad market has declined enough to no longer be Overvalued.

The purpose of identifying trends and being aware of tendencies in the stock market is to avoid The Big Loss. Remember, the primary objective of investing is to realize a return on investment.

I'd much rather be singing Kumbaya with the rest of the punditry, but that's not what we are all about. Investing is a business, not a game of chance. To survive, as an investor, you have to buy right, hold tight, and take flight when the time comes.

Considering there have been two major bubble bursts in the last 13 years, one would think that investors would be smart enough not to get sucked into the “this time it's different” mantra, which is currently on full display in almost any medium you choose.

I took a call the other day from a columnist asking me about 3M Corp. (MMM). “What do you think about 3M, Kelley?”

“Great company, love it; have lots of subscribers and clients with long-term positions in it.” “What do you think about buying it in here?” “No way, can't do it.”

“Three analysts just upgraded it. What are they seeing that you aren't?”

“I have no idea what their metrics are and how they measure value, but the way we analyze companies is identifying their dividend yield patterns and seeing whether they are within 10% of their low-price/high-yield area or the other way around. Right now, they're too close to their Overvalue area to buy.”

He then said the two magic letters; QE. “I think you're missing the boat here, Kelley. As long as the Fed is pumping, you can throw history out the window. We're in a new era man; the markets' got no place to go but up.”

And there you have it; this time is different. Funny, but I could swear I heard the same thing in 2000 and 2007.

Forget the facts, data, trends, and tendencies. When the “market has no place to go but up,” mentality kicks in, and what you'll have is a whole bunch of folks hoping and holding all the way down; it happens every time.

I know there are boat loads of folks who disagree with me; so be it. With the resilience this market has displayed, it is hard to blame them. “Facts are stubborn things,” I believe Samuel Clemens said. So are trends.

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