The market has largely recovered the most severe losses suffered in 2000 and 2001. The global war on terrorism is going fairly smoothly. Though slowing, the U.S. gross domestic product (GDP) remains healthy, and unemployment is under control. The money-eating monster known as inflation seems to be struggling to find a new victim. Personal income levels are higher. And NBC's Father of the Pride has been cancelled.
In short, we've had a pretty good run.
However, we live in a land of cyclicality, my friends. High times are inevitably followed by low times. I realize this philosophy isn't exactly going to win me the Ray of Sunshine award. The fact, however, is that we haven't fully paid the piper for the excesses wrought in the bubble years, and this means that equity multiples remain at historic highs.
The divergence
Thus, one of two things will probably happen: (1) We're on the verge of a new era that will see permanently higher equity multiples and stocks will maintain their current levels, or (2) stock prices will fall -- or do nothing for long periods -- until multiples return to their historic watermark. Here's a hint as to which scenario is most likely: There's no such thing as a new era.
At its core, the stock market is a fairly simple machine, being completely driven by supply and demand. Now, more individuals own stocks today -- either directly or indirectly through their 401(k)s -- than at any other time in history. Further, this trend is likely to continue. The boomers are growing older and retiring, which means they're going to require tools beyond CDs and passbook savings accounts in order to meet their investment goals.
Therefore, demand for equities will probably continue to rise over the next 20 years or more. So we could indeed see somewhat higher multiples being paid for stocks than in years past. However, such a change would be far more modest than the current deviation from historic earnings multiples.
Beyond that, as everyone who invested during the '90s bubble recalls, when folks start saying we're in a "new era" -- where the "old rules" no longer apply -- it's time to start heading for the door. Because of the market's beautiful simplicity, nothing beyond permanently higher demand could create a new era. Demand drives prices, and when that demand is withdrawn, prices fall. Period.
That leaves us with the second scenario: a crash or a long period of non-performance. Personally, I believe a crash is unlikely, as I just don't see a catalyst that would cause such an event. The factors that spawned the 1929 crash -- when neither the Securities and Exchange Commission (SEC) or Federal Deposit Insurance Corporation (FDIC) existed -- simply could not occur in the current environment.
The race for the door that was accelerated by computerized trading during the 1987 crash is equally unlikely. Then there are all the economic factors discussed in the first paragraph. No, I think it far more likely that we're going to see a long period of wheel-spinning.
Demanding return
So what to do? Well, frankly these are all reasons I choose to be a dividend-stock investor. It's also why I lead the charge over at Income Investor, the Fool's dividend newsletter service. Though most investors have only had a mind for capital gains over the past decade or two, a longer-term view makes a compelling case for locking in a portion of your return right now, today.
Today's investors have little memory of them, but there have been 10-20-year periods during which the major market averages have gone nowhere and produced nothing -- zero, zilch, nada.
Sure, I'm a fan of capital gains, but the truth is that such gains are great until they don't come to pass. Then you're left with the reality that your money has been sitting dormant for a decade or two and you have nothing to show for it. That's what makes me a dividend investor. If I choose wisely, I'm guaranteed at least some return year in and year out.
In market commentator John Mauldin's latest weekly e-letter, he cites a study by Jeremy Grantham, which demonstrates that -- during the 10 years following a period of low price-to-earnings (P/E) multiples -- the average annual return for stocks was 11% (i.e., the figure that your friendly neighborhood financial planner likes to quote). However, Grantham's study also shows that if you had invested during periods of high market multiples, your return over the following 10 years was zero. That's right, zero return for tying up your money for a decade.
Learn from history
As is the case in any other field, the most successful investors must become students of the game. In order to see the future, you must know the past. You must recognize that we are not in a new era, and that things will ultimately revisit past norms, especially something as straightforward as market demand.
Current P/E multiples make it highly unlikely that the market will deliver the 10%-11% return that financial pundits quote -- and investors have come to expect -- and far more likely that we'll see returns closer to that zero figure.
Still, let's split the difference and assume that the market can average returns in the 5%-6% range over the next decade. Just because we're not in a new era doesn't mean we can't take a new path. With such dividend-paying stocks as Newell Rubbermaid (NYSE:NWL) and Sara Lee (NYSE:SLE) yielding over 3.5%, owning these companies over pure growth stories such as Dell (NASDAQ:DELL) and Krispy Kreme (NYSE:KKD) means you're more than halfway to achieving a market-beating return -- that, of course, is the only reason to be a stock picker in the first place.
By cutting the level of capital gains needed to outperform the market to just 3%, you're giving yourself a huge advantage out of the starting blocks. Even better, investors who consistently reinvest their dividends will -- without a doubt -- outperform all other investors over time.
Heck, for that matter there are companies that come close to beating the market with their dividend yields alone. Consider Great Plains Energy (NYSE:GXP), whose 5.5% dividend yield goes a long way toward putting that outperformance notch in your belt. At that level, you'd need just a couple of percentage points of capital gain to virtually guarantee a market-beating performance over the long haul. New ZealandTelecom's (NYSE:NZT) near-6% dividend accomplishes the same feat.
The Foolish bottom line
The end result is that there couldn't be a better time to take advantage of dividend power. Lower market returns and the fact that aging yet longer-lived baby boomers are going to require both income and growth means that dividend-paying stocks are going to see increased demand.
If you're interested in employing the dividend advantage, consider joining the movement via a risk-free 30-day free trial to Motley Fool Income Investor. There, I give my readers two quality dividend-paying stock ideas each month, complete with ongoing coverage and pertinent advice.
Better still, even in this higher-return market, our dividend-based strategy is beating the market averages twice over while taking half the risk -- and locking in a 4.5% dividend yield in the process. Whether you join the service or you prefer to do it yourself (you can use these tips to find dividend-paying winners on your own), you owe it to your portfolio to check out the power of the dividend.
Fool on!
Mathew Emmert likes 0% returns about as much as a root canal. In case you didn't notice, he's the lead analyst of Motley Fool Income Investor. Mathew doesn't own shares in any of the companies mentioned in this article. The Fool has an ironclad disclosure policy.
