May 20, 2009 Letters to the Editor

Updated: June 1, 2009.

The Housing Market Isn't Efficient Either

I received this letter from Rob Bennett.

The point you make in your Note "How TIPS Could Go Sour" is well taken.

The root problem is once again the Efficient Market Theory. Or, if you really want to go cosmic re all this, the root problem is the idea of Economic Man or Rational Man that goes all the way back to Adam Smith and that is core to Classical Economics (pre-Keynesian economics or "conservative" economics) and to much of the libertarian economic philosophy.

I have been arguing for some time now that the papers should report not only the DOW and S&P 500 numbers but also those same numbers after an adjustment for valuations is applied to them. That applies with housing prices too. If people had known during the housing bubble how little in the way of real housing they were getting for their dollar, they would have refused to pay the prices being asked and that refusal would have brought prices back down to reasonable levels.

Markets are self-regulating. That's what Classical Economics teaches. And this is to a large extent indeed so.

But it is not necessarily so. Markets are self-regulating ONLY if market participants are INFORMED.

For so long as market participants are being kept in the dark as to the true (valuation-adjusted) values of the things they are purchasing (whether stocks or houses), the markets are NOT self-regulating. For so long as we as a society continue to entertain the fiction that markets are AUTOMATICALLY efficient, they will remain wildly inefficient.

Markets can be made efficient. It depends on what the humans do. If the humans elect to educate themselves as to the effect of price on long-term value propositions, the markets will BECOME largely efficient as a result of us performing that critical step.

The entire economic crisis resulted from our failure to take that step. A free market economy simply cannot work unless market participants are made aware of the extent to which the markets have become inefficient as a result of valuation changes. Retirees are in a bad place because they did not know the true value of the stocks they were buying or of the houses they were buying. Our economic system cannot work unless we work up the courage as a society to begin sharing this information with all market participants.

The solution seems so simple. And yet the need to give voice to the three magic words makes it all appear so complicated to the most influential among us.


Thank you once again for a well thought out letter.

The real estate bubble was known. Professor Shiller warned us about it in Chapter 2 of the Second Edition (2005) of “Irrational Exuberance.” These days we can track big city home prices using the Case-Shiller index. Professor Shiller made it clear that housing had gone into a serious bubble.

Past attempts to eliminate economic downswings have led to the formation of bubbles. Bubbles end badly. But heading off a bubble has serious political penalties.

Notes starting from May 5, 2009


I received this letter from Bob. It is in a conversational style.

Am getting into your site more and more. I sort of know you, first from Bogleheads (boy, you could sure say I told you there, but they wouldn't let you post I'm sure) and M*. Read Shiller and as mentioned navigating your site. One critique, lots of layers to go through, not always easy. E.g. saved as favorite page the average P/E10 per decades, then tried to find without benefit of my shortcut. Finally located via entering Shiller in search. Anyhow, your content am increasingly enjoying. As fan hope it grows, perhaps an advertiser to help with organization, and lay-out? But in any event, I have come to enjoy and respect your information and commentaries.


Thank you for your kind words.

I appreciate the difficulty of getting around at my site. To a large extent, this is the result of my having a research site. I literally do not know where my research will lead next.

To a lesser degree, the market meltdown has changed the whole orientation of the site. It is no longer necessary to warn retirees about high valuations and the danger of a price drops. Today’s focus has shifted to a different market, much more favorable ten years from now, but potentially dangerous along the way. People can now see the merits of a delayed purchase, now that a meltdown has already occurred. Another meltdown could easily be in our future. We need to be able to take advantage of it, should it occur. We need to protect ourselves as well. As a minimum, we need to prepare ourselves emotionally. Looking out a decade, we can be secure. But it could be bumpy along the way.

Investment Return Calculation

I received this letter from Rob Bennett. I am sure that he is not alone in asking this question.

Here is a line from your Note for today:

"The investment return (roughly) equals the initial dividend yield plus the annual growth rate of the dividend amount."

I have never been able to understand what "the annual growth rate of the dividend amount" is.

Is it possible to provide an example of how this works?


Thank you. You are not alone. From my standpoint, it is necessary to word things very carefully for the mathematically inclined. Understanding calculation details can be very difficult for those who are not numbers oriented.

Here is my plain English explanation: it is the percentage increase in the dividend amount from one year to the next. If the dividend amount was $1.60 two years ago and if it was $1.72 last year, the dividend amount has grown to 1.72/1.60, which equals 1.075. The percentage growth rate is 7.5%. That is, you subtract 1.0 from the ratio and then multiply by 100%.

You must be very careful to use dividend AMOUNTS in this calculation. You cannot use dividend yields for they include the effect of price, which varies.

If you have several years of dividend data, you use the dividend amount at the end of the period and the dividend amount at the beginning of the period. If there are n years, the formula is:

(1+growth rate)^n = (dividend amount at the end of n years)/(dividend amount at the beginning of n years).

After solving, you multiply the growth rate by 100% to convert it to a percentage.

Notice that both the yield and the growth rate of the dividend amount are in percentages, not fractions.

With typical growth rates, the formula can be approximated by:

growth rate in percent = 100%*(1/n)*[(dividend amount at the end of n years)/(dividend amount at the beginning of n years)-1.0].

For example, if the dividend amount were to grow from 1.60 to 2.20 in five years, the growth rate would be close to 100%*(1/5)*[(2.20/1.60)-1.0] = 100%*(1/5)*[1.375-1.0] = 100%*(1/5)*[0.375] = 7.5%.

The exact calculation would be (1+growth rate)^5 = (2.20/1.60) = 1.375. Taking the fifth root, (1+growth rate) = 1.0658. Solving, growth rate = 0.0658 or 6.58%.

Typically, estimates of the growth of the dividend amount are unreliable beyond two or three years. There is no need to strive for precision.

Yahoo Finance provides dividend information on individual stocks. As a reference: the S&P500 index has grown 5.5% per year (nominal) over long periods of time.

The Investment Return formula is best used for calculation the nominal return followed by an adjustment for inflation. This is because the growth rate in the nominal dividend amount is usually steady, but inflation jumps around considerably. However, for those who wish to calculate the real Investment Return directly, use inflation adjusted dividend amounts. The initial dividend yield is the same, regardless of whether you are using nominal or real dollar amounts.

Statistical Lessons Learned

Can We Measure Whether Dividend Payouts Are "Keeping Up" with Price Increases?

I received this letter from Rob Bennett.

Thanks for your response to my question about the calculation of the annual growth rate of the dividend amount. I'd like to run a few follow-up questions past you, if that is okay.

1) You say that the S&P [dividend amount] had grown 5.5 percent nominal over long periods of time. Can this nominal number be translated into a real number? I understand that inflation jumps all over the place. But is it possible to use the average inflation adjustment to translate the long-term nominal S&P dividend growth number into a long-term real S&P dividend growth number?

2) If it is possible to identify a long-term real S&P dividend growth number, is it right to think that the total average real return for the S&P (something in the neighborhood of 6.5 percent) should match the combination of the initial S&P dividend amount and the long-term real S&P dividend growth number?

3) Presuming that one views the speculative return as being of no value for long-term investors, is it fair to say that in any year in which the dividend is not increased by enough to cover the increase in the stock price, the investor is in a sense falling behind? For example, say that the dividend on a $100 share is $5. The price of the share increases over three years to $200 but the dividend remains $5. In these circumstances, could it be said that the investor has fallen behind (presuming that he counts the $200 share price as real). He now has a $5 dividend on $200 worth of stock rather than a $5 dividend on $100 worth of stock.

4) If the concept described in Question 3 makes sense, is it possible to determine on a year-by-year basis how S&P investors are doing by seeing whether the dividend payout they are obtaining is keeping pace with the growth in the price of the index? Is it possible that there were years in the 1990s in which S&P investors thought they were doing well because they focused on the price of the index to assess where they stood but that they were really falling behind on a price-adjusted basis in the sense that the dividend payout was not "keeping up" with the price increase?

Thanks for any help you are able to offer with some questions that have long been puzzles for me.


Thank you.

1) Yes. To convert from nominal to real rates, you divide (1+nominal rate) by (1+inflation). Since the nominal dividend growth rate is 5.5% and the long term inflation rate is around 3.5%, (1+real rate of growth) = (1.055)/(1.035) = 1.0193 or the real rate of growth = 1.93%.

Notice that this is very close to nominal growth rate minus the inflation rate. Because the numbers are approximate, most people would simple subtract 3.5% from 5.5% and quote the real rate of growth as 2.0%. It is close, but not exact.

2) Yes, it is reasonable. The formula would be INVESTMENT RETURN = initial dividend yield + 1.93%. Unfortunately, however, this formula does not work. It is approximately true at Year 10.

I addressed this in my article “Time and the Gordon Model.” The mathematics breaks down because the dividend yield varies with time. Reinvested dividends may return more or less than indicated by the formula.

Still, we can solve the formula backwards. The initial dividend yield should be 6.5%-2% = 4.5%. There was a positive SPECULATIVE RETURN caused by expanding multiples throughout the twentieth century. It was just below 1%. This suggests a typical dividend yield of 3.5% to 4.5% for the S&P500 index. This is a reasonable result.

3) For the price of a share to be accurate, it must represent some multiple of smoothed earnings. If the dividend falls behind when the price is accurate, the payout ratio has to fall. That is, the dividend has fallen to a lesser percentage of smoothed earnings. This is a warning signal to a dividend oriented investor. Most likely, the company’s dividend policy has changed. From a dividend investor’s standpoint and often from the viewpoint of other investors, this is bad news. Management may be seeking acquisitions. Although some acquisitions work out well, many do not. The risk has increased.

A more likely possibility is that the price increase was the result of being discovered as a value opportunity by the public. If so, it becomes less of a value.

Regardless of the details, dividend investors would normally sell these shares to purchase shares in a good company with a higher yield.

4) The price to dividend ratio (and its reciprocal, the dividend yield) is a traditional measure of value. If you smooth the dividend amount over several years, it becomes a good alternative to P/E10. Both P/D5 and P/D10 are excellent predictors, comparable to P/E10.

The payout ratio declined gradually throughout the end of the twentieth century. It was still reasonable, however, even in Year 2000. Just as P/E10 zoomed to new heights in the late 1990s, the dividend yield fell very low. The price to dividends ratio went through the roof. Reduced payout ratios were not the problem. Price increases were the problem.

Yes. The dividend yield is a good proxy for the percentage earnings yield 100E10/P. It does especially well when you use smoothed dividend amounts.

Time and the Gordon Model

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