This week we look at two very intriguing studies, one from James Montier where, safely perched in England, he forecasts future real returns on the US stock market. Then we give you Master Trader Dennis Gartman's 22 Rules of Trading, many of which you can apply to all sorts of life situations, as well as the markets.
I really need to thank these two gentlemen for letting me use their work almost verbatim, as I am finishing the last (!) chapter of my book this weekend and really need every hour I can get (see more below). In any case, readers will be well served by these two short epistles.
Montier is the Global Equity Strategist for Dresdner Kleinwort Wasserstein and also the author of the well reviewed and very readable (thus unusual in its field) book called Behavioural Finance - Insights Into Irrational Minds and Markets. He writes a weekly thought piece for institutional investors, and I edit his letter from this week. He gives us a forecasting model for the future real returns for stocks from the US, the UK, Europe and Japan. I think readers will find this of real value. I have edited the work, so any mistakes or problems are mine. My personal comments are in brackets. And now to his writing.
Dividends Do Matter
We have written many times before on the importance of dividends to investors. And we continue to stand by this view. A dividend represents the actual cash returned to an investor in relation to their ownership of the company.
Our previous work has been an analysis of the US and UK long run data. We have recently come across data for a far wider sample to explore. For those who are unfamiliar with our approach, here is a brief summary. The total real return an investor receives can be decomposed into three components:
- the dividend yield,
- any growth in real dividends, and
- any change in valuations over the holding period.
Of course, during the long bull market, dividends became a dirty word. When earnings growth was seemingly invincible, only the truly dull would concern themselves with the miniscule return embedded in the dividend yield.
It is easy to see how investors ended up in this situation. Looking at the period 1995-2000, over 80% of the return achieved was generated through multiple expansion - an unprecedented contribution from this element! Such an occurrence has never before happened. [By multiple expansion Montier means the increased value that an investor puts on the value of earnings. That means a rising P/E ratio and not the actual growth of earnings was responsible for 80% of the increase in the value of the stock market from 1995-2000.) However, we know that people tend to extrapolate the more recent past into the future. So it is easy to see why investors tend to think that price appreciation is the best way of accessing returns.
However, a longer time horizon exposes the fallacy of this view. Taking a broader view of history shows that dividends are far more important than the experience of the late 1990s would suggest. For instance, decomposing the returns from the US market over the long run since 1900 reveals that some 66% of the total return was generated by the dividend yield.
Investors sometimes question the quality of the early data, so examining the post War data from 1950 helps bypass this concern. Ironically, the case for the importance of dividends is strengthened rather than weakened by the focus on this sub-sample. Between 1950 and 2000 some 72% of the total return an investor achieved was delivered via the dividend yield!
Just in case you are wondering, stock repurchases don't alter this picture to any meaningful degree. Repurchases added 73 basis points (0.73%) to the dividend yield on average between 1995-2000. Besides which, the above analysis deals in per share data, hence any repurchases should have increased the future rate of growth, so the whole repurchase issue is something of a red herring in the current context.
Whenever we have presented this work in the past we get asked if we have the data for any other countries. Until very recently we have been unable to perform similar analysis on any other country except the UK. However, we recently came across data that allows us to explore this issue in a far wider context. The data are drawn from the masterful study of returns, "Triumph of the Optimists" by Dimson, Marsh and Staunton.
The results from our analysis of the data show that the US isn't an isolated case. Across nine major global markets we find that an average 65% of total return has been generated by the dividend yield since 1950.
A quick glance at the data reveals a remarkable consistency to the importance of dividends. For instance, in Europe (excluding in this case the United Kingdom) the average contribution of dividend yield to total real returns has been 62%. So, nearly two thirds of investors' total real returns in the European (ex UK) arena are provided by dividends.
Of the countries considered only Germany stands out as having a remarkably low contribution to total returns stemming from the dividend yield (just 30%). Effectively Germany has been one of those rarest of creatures - a growth story that actually worked! However, the tangible growth of Germany is played out still via the actual growth in dividend yield of 65% (thus showing that the only true growth is still perhaps tied to dividends).
All of this is interesting, but can it tell us anything about the future? We believe the answer is yes. We view the framework set out in the beginning of this piece (that total return from stocks can be characterized as the dividend yield, any growth in real dividends, and any change in valuations over the holding period) as an example of the "decomposition" approach to forecasting.
In the book Principles of Forecasting (2001), Donald MacGregor defines decomposition as: A method for dealing with problems by breaking down the estimation task into a set of components that can be more readily estimated and then combining the component estimates to produce a target estimate.
There is a large literature from psychologists on the benefits of decomposition forecasting. But the basic idea is very simple. Using a building blocks approach to (in our case) estimating returns is likely to be less subject to behavioral biases than simply trying to come up with a return forecast in totality.
The equation we would use is: the real return = Dy [dividend yield] + real g [growth in dividend yield] + delta P/D [change in the valuations or price of the shares in terms of dividends].
What parts of the equation will change? Given that most markets are either fair value or [as in the case of the US] expensive then it would seem unrealistic to forecast further multiple expansion in the long term. Hence we are left with the dividend yield plus the real growth rate of dividends.
The dividend yield part of the equation is obviously easily available. However, the growth rate causes investors much angst. Believers in market efficiency argue that low dividend yields must be offset by higher future growth rates (the Modigliani and Miller theorem (M&M)). We have shown elsewhere [and convincingly - John] that this is not a good description of the US.
In fact, if anything there is a 'perverse' relationship between dividend yields and long term dividend growth in the US: higher yields tend to go with higher dividend growth! However, this appears to be the result of a few outliers [data which is either very high or very low from the median and which distorts the averages]. However, even removing these, you would be hard pushed to find any relationship at all. Hence, still a poke in the eye to M&M.
[Montier goes into a long discussion of the above principles in the European markets and demonstrates roughly the same conclusion- John.]
Given reasonable skepticism over M&M, some choose to plug GDP growth rates in as a substitute for long-term dividend growth. However, this ignores the dilution effect, and the non-listed firm effect. As Arnott and Bernstein (2003) show, dividends have consistently grown below the rate of growth of the economy in the US. And we found similar results in an international extension of their work. [Readers may remember I did an extensive review of Arnott and Bernstein's work a few months ago.]
The Ice Age
Given these difficulties we have chosen to use the historic real rate of growth in dividends as our proxy for g [growth in dividends]. Plugging all the numbers (no growth in valuation, current dividend yield and historic growth in dividends gives us an expected real return of 2.5% for the US markets. Real returns for the United Kingdom is forecast for 6%, Europe (ex UK) is 4.3% and Japan is 1.3%.
This is in line with our long held argument that in a world of low returns (i.e., what Montier calls The Ice Age, a slow period of real returns) dividends will be an increasingly important source of return generation for investors.
Some investors see this low return forecast as part of the normal consensus, and hence seem to give it scant regard. Yet these self same investors are happy to play the greater fool/sucker rally that we are currently witnessing. We suspect that they are performing the investment equivalent of St. Augustine of Hippo's plea: "Lord, make me chaste, but not yet" - a near perfect example of cognitive dissonance.
Perhaps investors would be better advised to heed Confucius' sagely words "If a man gives no thought about what is distant, he will find sorrow near at hand."
The 22 Rules of Trading
Every day, Dennis Gartman gets up at bout 2:30 AM and writes an information packed 4 page newsletter on the world markets, oil, currencies, commodities political happenings and much more. He is read by the major trading houses and traders all over the world, as they stumble bleary eyed into work, grabbing the Gartman Report to find out what happened as they slept and to get insight as to what the issues of the day will be, and suggestions on how to trade. Dennis puts his trades on public display and talks you through his logic. It is a most remarkable work, and I find it a key part of my struggle in trying to keep up with what is going on. I am always amazed when on the occasions I find myself in the office at an early hour to find Dennis' letter hit my inbox about 5:00 AM. His travel schedule makes mine look tame, and from wherever in the world he finds himself, he writes and sends his letter. And he still maintains a single digit handicap on the golf course.
On the Friday after Thanksgiving, he publishes his "Rules of Trading," adding to them as wisdom increases. Here is today's list:
1. Never, under any circumstance add to a losing position.... ever! Nothing more need be said; to do otherwise will eventually and absolutely lead to ruin!
2. Trade like a mercenary guerrilla. We must fight on the winning side and be willing to change sides readily when one side has gained the upper hand.
3. Capital comes in two varieties: Mental and that which is in your pocket or account. Of the two types of capital, the mental is the more important and expensive of the two. Holding to losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital.
4. The objective is not to buy low and sell high, but to buy high and to sell higher. We can never know what price is "low." Nor can we know what price is "high." Always remember that sugar once fell from $1.25/lb to 2 cent/lb and seemed "cheap" many times along the way.
5. In bull markets we can only be long or neutral, and in bear markets we can only be short or neutral. That may seem self-evident; it is not, and it is a lesson learned too late by far too many.
6. "Markets can remain illogical longer than you or I can remain solvent," according to our good friend, Dr. A. Gary Shilling. Illogic often reigns and markets are enormously inefficient despite what the academics believe.
7. Sell markets that show the greatest weakness, and buy those that show the greatest strength. Metaphorically, when bearish, throw your rocks into the wettest paper sack, for they break most readily. In bull markets, we need to ride upon the strongest winds... they shall carry us higher than shall lesser ones.
8. Try to trade the first day of a gap, for gaps usually indicate violent new action. We have come to respect "gaps" in our nearly thirty years of watching markets; when they happen (especially in stocks) they are usually very important.
9. Trading runs in cycles: some good; most bad. Trade large and aggressively when trading well; trade small and modestly when trading poorly. In "good times," even errors are profitable; in "bad times" even the most well researched trades go awry. This is the nature of trading; accept it.
10. To trade successfully, think like a fundamentalist; trade like a technician. It is imperative that we understand the fundamentals driving a trade, but also that we understand the market's technicals. When we do, then, and only then, can we or should we, trade.
11. Respect "outside reversals" after extended bull or bear runs. Reversal days on the charts signal the final exhaustion of the bullish or bearish forces that drove the market previously. Respect them, and respect even more "weekly" and "monthly," reversals.
12. Keep your technical systems simple. Complicated systems breed confusion; simplicity breeds elegance.
13. Respect and embrace the very normal 50-62% retracements that take prices back to major trends. If a trade is missed, wait patiently for the market to retrace. Far more often than not, retracements happen... just as we are about to give up hope that they shall not.
14. An understanding of mass psychology is often more important than an understanding of economics. Markets are driven by human beings making human errors and also making super-human insights.
15. Establish initial positions on strength in bull markets and on weakness in bear markets. The first "addition" should also be added on strength as the market shows the trend to be working. Henceforth, subsequent additions are to be added on retracements.
16. Bear markets are more violent than are bull markets and so also are their retracements.
17. Be patient with winning trades; be enormously impatient with losing trades. Remember it is quite possible to make large sums trading/investing if we are "right" only 30% of the time, as long as our losses are small and our profits are large.
18. The market is the sum total of the wisdom ... and the ignorance...of all of those who deal in it; and we dare not argue with the market's wisdom. If we learn nothing more than this we've learned much indeed.
19. Do more of that which is working and less of that which is not: If a market is strong, buy more; if a market is weak, sell more. New highs are to be bought; new lows sold.
20. The hard trade is the right trade: If it is easy to sell, don't; and if it is easy to buy, don't. Do the trade that is hard to do and that which the crowd finds objectionable. Peter Steidelmeyer taught us this twenty five years ago and it holds truer now than then.
21. There is never one cockroach! This is the "winning" new rule submitted by our friend, Tom Powell.
22. All rules are meant to be broken: The trick is knowing when... and how infrequently this rule may be invoked!
New York, New York
I am off to New York on Tuesday to speak at a Bank of New York conference. The speech is titled "Hedge Funds - The Tectonic Plate Shift in the Markets." My book will be finished before I get on the plane. New chapters and research will simply have to go into this weekly letter.
For those who are interested and who qualify, I write a free letter on hedge funds and private offerings called the Accredited Investor E-letter. You must be an accredited investor (broadly defined as a net worth of $1,000,000 or $200,000 annual income - see details at the website.) You can go to www.accreditedinvestor.ws to subscribe to the letter and see complete details, including the risks in hedge funds. (In this regard, I am a registered representative of the Williams Financial Group, an NASD member firm.)
I trust your Thanksgiving was as enjoyable as mine. My bride (she who must be obeyed) has dictated that next year I will take the entire Thanksgiving holiday off, to make up for being in the office writing every day. I will accede to her wisdom.
As a final note, we bought the extended version (4 hours) of the second part of the Lord of the Rings and watched it last night. It is magnificent in scope and beauty. It is a paean to the rightness of fighting against evil, even when it seems overwhelming and loss seems almost certain. My daughter's boyfriend, noting my love of Tolkien, has gifted me with a press pass to see the preview of the third and last part, The Return of the King, next Tuesday morning, two weeks in advance of it hitting the public screens. The latest version will be a hymn to the triumph of good over evil, but noting the costs of the battles.
I highly recommend you read the book over the holidays, if you have not, and return to it once again if you have. It is one of the finest examples of true word craft in the English language, and will inspire you in your own day to day life to continue the good fight.
Your fighting the good fight to get through his book analyst,