Summer Stroll #3 -- Volatility Feels Like Risk

Please begin at the beginning of the Summer Stroll blogs to best understand this edition. The question always comes up, why dividends when Wall Street focuses on earnings and earnings are required to pay dividends? I always admit that earnings are, indeed, the most important ingredient to a successful investment, but earnings share a common trait with prices -- high volatility. As mentioned in the last piece, stock prices, exclusive of dividends, have grown at an annual rate of 6.7% over the last 45 years. During this same time earnings have grown at an average annual rate of 7%. Remember also that dividends have grown at 5.4%. Now, 7% sounds a whole lot closer to the 6.7% annual growth of price than the 5.4% growth of dividends, so again, why use dividends as the best indicator of true investment value? The title of this piece should give it away, volatility. Stock prices have an annual standard deviation of near 15%. That means that in a normal year we should expect stock prices to range from -8.3% (15%-6.7%) to +21.7% (6.7%+15%). This means that about 28% of the time we should expect stocks to fall, or about once every three to four years. There are all kinds of behavior studies that show that people are not very good losers. They wrongly conclude that things have changed and there will be no return to the three up years for every down year. I have managed money for a long time, and I can tell you this is absolutely true. People get crazy when they have a sizeable loss in their portfolio. But the reality of the situation is that losses are unavoidable. You must take the bad with the good, but you must have something to hang your hat on, other than prices, because prices will spook you on a fairly regular basis. And the bad news is, even though earnings have grown at about the same rate as prices, they are even more volatile. Earnings for the Dow Jones 30 have an annual standard deviation of near 22%. That means earnings in a normal year will be somewhere between -15.3% and +28.7%. Earnings simply do not help us make it through the bad years, they are more nerve wracking than prices. Now comes the lowly dividend. It has averaged 5.4% growth, but its standard deviation is only about 8%. Now we are talking. That means in a normal year we would expect dividends to produce between -2.6% and a +13.4%. It is the dividend's stability that gives it its power in predicting future stocks prices, as well as to help us to hang in there during the down years in price. Falling dividends represent only about a 16% probability, thus if you are watching dividends it is rare to have a bad year, so to speak. Now here is the important statistic to keep in mind. There is a 92% correlation between price and dividend. If we add interest rates, we can get the correlation up to almost 95%. We use the term: So goes the dividend, so goes the price. Dividends have the highest volatility adjusted correlation to price of any fundamental data, and that is the main reason we use them to determine "investment value." Couple this with the fact that dividends are real money and have represented 36% of the total annual return of stocks for the last 45 years, and we now have a powerful weapon with which to go hunting in the investment jungle. PS. I can't answer every question, but toss something out. It's a little quiet in here.