Failure Mechanism

The Gordon Equation (and other forms of the Dividend Discount Model) helps explain why stock prices will decline over the next few years (after adjusting for inflation).

Total Return = Investment Return + Speculative Return

The Investment Return is tied to the economy and smoothed earnings. It is relatively stable, especially when measured over a number of years. The Speculative Return of stocks depends on multiples such as the price to earnings ratio P/E or the price to dividends ratio (1/dividend yield). It fluctuates a lot.

The Investment Return = initial dividend yield (percentage) + dividend growth rate (the increase in the dividend amount per year as a percentage).

The Speculative Return = the final P/E ratio divided by the initial P/E ratio converted to an annualized percentage. For most accurate results, use smoothed earnings (e.g., use Professor Robert Shiller’s P/E10).

When the initial P/E ratio is high, as it is today, the Speculative Return over a period of years is less than one. The Speculative Return drags down the total return.

A long period of subpar returns causes investors to look elsewhere. This causes stocks to fall below fair value. They fall to bargain levels. They fall so far that it pays to wait on the sidelines, preserving capital.

Have fun.

John Walter Russell
A Note from early February 2008