The subject of valuing stocks by their dividend is discussed in the June AAII Journal, which was posted to our website yesterday. Specifically, Computerized Investing editor Jaclyn McClellan takes an in-depth look at Geraldine Weiss’ approach. I’m going to extend the conversation by discussing Weiss’ and other dividend valuation strategies.

Weiss used a relative valuation approach. Using 10 years of dividend data—20 years when possible—she plotted a stock’s yields to identify its dividend cycle. Doing so alerted her to when yields were high on a historical basis (implying a low valuation) and when yields were low on a historical basis (implying a high valuation). She determined when to buy and sell based on this information. Specifically, she targeted stocks trading within 10% of their historical high yields and sold stocks trading within 10% of their historical low yields.

Those of you who incorporate technical analysis will be familiar with this type of strategy. It is akin to using a stock’s price range or channel. For both relative yield and technical analysis strategies, decisions about the attractiveness of the stock are based on how investors have historically reacted to the stock’s price and valuation movement.

An alternative method is to compare the stock’s yield relative to the universe of exchange-listed stocks. If a stock’s yield is above the market average, it is cheap on a relative basis. If the yield is below the market average, it is expensive. (Yields and valuations are inversely related, with a low yield implying a high valuation and vice versa.) We consider relative yield as part of our approach to managing the AAII Dividend Investing portfolio. Our reason for doing so is because a stock’s yield can be at the high end of its historical range and still be way below the market’s average.

Consider a stock yielding 1.0%. If this stock has historically traded within a high/low range of 1.0% to 0.5%, it looks cheap relative to what investors have been willing to pay in the past. Comparing the stock to the broader market results in a less favorable valuation. The market—as measured by the Dow Jones U.S. ETF (IYY)—currently yields 2.0%. This means an investor can get twice the yield by simply owning a broad market index. Granted, there may be other reasons to own the stock, such as strong earnings growth, but for a dividend-oriented investor, the stock is not very attractive. Hence, when using any valuation strategy, it’s always helpful to take a step back and consider the broader picture.

There is a limit to looking for higher-than-average yields, however. Data from both James O’Shaughnessy and Dartmouth professor Kenneth French show higher yields only lead to higher returns up to a certain point. Why would this be the case? Stocks with the highest yields are those most likely to be perceived as risky by investors. Often, but not always, the perception is justified, with such companies encountering financial problems and hence incurring lower returns.

It’s also possible to value a stock based on the present value of its future dividend payments. To do this, you will need to be reasonably accurate in forecasting what the future dividend stream will be and correctly determine the minimum rate of return you would require to part with your money today in exchange for a future stream of income. Both steps require making assumptions about the company’s growth rate and future interest rates. The likelihood of getting these assumptions wrong is high.

No single approach is perfect. Caveats exist with all valuation methods. Market valuations rise and fall. Business risks change. And while an investor’s short-term perceptions may be very wrong, other times they are justified. Attempts to forecast future returns and growth rates come with their own risks.

One advantage to using a relative valuation approach is its simplicity. Complexity may give an aura of confidence, but it also creates more room for assumptions to be incorrect.

• Calculating Intrinsic Value with the Dividend Growth Model – Specific instructions to how to use the dividend discount model to calculate a stock’s value.
  
• Weiss Blue Chip Dividend Yield Screen – This AAII stock screen identifies stocks based on Geraldine Weiss’ approach.
  

Only three members of the S&P 500 will report earnings: Brown-Forman Corporation (BF.B). on Wednesday and both J.M. Smucker Co. (SJM) and H&R Block (HRB) on Thursday.

The week’s first economic report will be revised first-quarter productivity, which will be released on Tuesday. Wednesday will feature the Labor Department’s Job Openings and Labor Turnover Survey (JOLTS) for April. The University of Michigan’s preliminary June consumer sentiment survey will be released on Friday.

Just two Federal Reserve officials will make public appearances: Boston president Eric Rosengren and Federal Reserve Chair Janet Yellen on Monday.

The Treasury Department will auction $24 billion of three-year notes on Tuesday, $20 billion of 10-year notes on Wednesday, and $12 billion of 30-year bonds on Thursday.

Optimism among individual investors about the short-term direction of stocks rebounded strongly in the latest AAII Sentiment Survey. The rise followed two consecutive weeks of extraordinarily low levels of bullish sentiment. At the same time, neutral sentiment plunged after having reached a 26-year high last week.

Bullish sentiment, expectations that stock prices will rise over the next six months, jumped 12.4 percentage points to 30.2%. Though a six-week high, optimism is only at the lower end of its typical historical range. Furthermore, bullish sentiment remains below its historical average of 38.5% for the 30th consecutive week and the 63rd out of the past 65 weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 12.1 percentage points to 40.8%. Even with the significant drop, neutral sentiment remains at an unusually high level. This is the 13th consecutive weekly reading above 40% and the 18th consecutive week that neutral sentiment has been above its historical average of 31.0%.

Bearish sentiment, expectations that stock prices will fall over the next six months, declined 0.3 percentage points to 29.1%. Pessimism is below its historical average of 30.5% for the 12th time in the past 14 weeks.

As noted above, this week’s big change in bullish and neutral sentiment follow what had been extraordinarily low and high, respectively, readings for both measures. Even with the big changes, optimism remains low and neutral sentiment remains high. Pessimism is close to, though technically below, its average.

Giving individual investors cause for concern is the slow pace of U.S. economic growth and uncertain pace of global economic growth, terrorism and global unrest, lackluster corporate earnings, the prevailing level of valuations, the forthcoming election and monetary policy. Some AAII members, however, are encouraged by sustained domestic economic growth, corporate earnings and still comparatively low energy prices.

This week’s special question asked AAII members how big of an impact news and data about Europe, including Great Britain, is having on their outlook for the U.S. stock market. Nearly three out of five respondents (58%) said it was either not affecting their outlook or only having a small impact. Many of these individual investors added that domestic events (including the Federal Reserve, the economy and the November elections) are having a bigger impact on their U.S. market outlook. Slightly more than 19% said that events in Europe are having some impact. Just under 12% said Europe is or could have a significant impact due to Great Britain’s referendum on the European Union membership (“Brexit”) and/or its economy’s influence on U.S. multinational corporate profits.

Here is a sampling of the responses:

• “No impact from Europe and Great Britain. I feel that the U.S. political arena is the significant factor.”
• “None. What the Fed does and whether the U.S. economy can break out of continuing weakness are dominating my decisions.”
• “Not much. I don’t think Great Britain will withdraw from the European Union.”
• “I think the Brexit and general European outlook will affect the U.S. market somewhat, but not critically.”
• “Small impact, but I am watching closely.”

Bullish: 30.2%, up 12.4 points
Neutral: 40.8%, down 12.1 points
Bearish: 29.1%, down 0.3 points


Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%

Exposure to fixed income in individual investors’ portfolios continued to rise last month, according to the latest AAII Asset Allocation Survey. May’s increase was the ninth in the past 10 months. Cash allocations rebounded, while equity allocations declined.

Stock and stock fund allocations declined 1.9 percentage points, to 62.9%. The decline follows last month’s 2016 high. Even with the decrease, equity allocations are above their historical average of 60.5% for the 38th consecutive month.

Bond and bond fund allocations rose 0.2 percentage points, to 17.8%. The increase keeps fixed-income allocations at their highest level since May 2013 (18.1%). The rise also puts bond and bond fund allocations above their historical average of 16.0% for the 10th consecutive month.

Cash allocations rebounded by 1.7 percentage points, to 19.3%. The rebound occurred after cash allocations had fallen to an eight-month low in April. Even with May’s increase, cash allocations remain below their historical average of 23.5% for the 54th consecutive month.

The increase in fixed-income allocations has been gradual. Since July 2015, bond and bond fund exposure has risen by a cumulative 2.3 percentage points. Over the same period of time, stock and stock fund allocations have declined by 4.5 percentage points.

May’s special question asked AAII members if, given $50,000, how they would invest it today. Nearly two-thirds of respondents (65%) said stocks or stock funds. Dividend-paying stocks were a particular favorite, picked by more than 11% of all respondents. Nearly 20% said they would keep some or all of the amount in cash. About 17% said they would buy bonds or bond funds. Several respondents listed more than one investment or asset class.

Though optimism about the short-term direction of the stock market fell to extraordinarily low levels during the latter part of May, many individual investors feel the alternatives aren’t any more attractive. Continued low bond yields and low interest rates on money market and bank savings accounts remain a source of frustration for many individual investors.

Here is a sampling of the responses:

• "Dividend-paying stocks. Better returns than CDs or bank interest rates.”
• "Stocks. They have the best and highest long-term returns.”
• "Bonds, dividend stocks and cash. Even though the returns should be lower, I don’t believe the volatility will be as great.”
• "Cash. The markets are pretty high and the world economy is unstable.”
• “Cash, gold: 40%; stock and stock funds: 30%; real estate: 30%; spread the risk in case of a big market crash.”

• Stocks and Stock Funds: 62.9%, down 1.9 percentage points
• Bonds and Bond Funds: 17.8%, up 0.2 percentage points
• Cash: 19.3%, up 1.7% percentage points

• Stocks: 31.5%, up 0.8 percentage points
• Stock Funds: 31.4%, down 2.7 percentage points
• Bonds: 4.4%, up 0.5 percentage points
• Bond Funds: 13.4%, down 0.2 percentage points

Take the Asset Allocation Survey.

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