How to Tell When Stocks Are Undervalued ?
There are several indicators I have used and found to be extremely valuable in calling major market bottoms. While there are several ways of looking at what forms a market bottom, one would be the fundamental scenario. There’s a great deal of significance to what the yield is on the Dow Jones Industrial Average. The yield is the amount of cash return investors get from companies in the form of dividends.
In the past, stock market highs typically developed with the yield of the Dow Jones Industrial Average somewhere under 3 percent. That was an extremely good rule until the 1980s and 1990s, when, for whatever reason, stocks continued churning ahead despite the very low yield in the Dow. The yield is a measure of value or quality. Not paying dividends is usually (not always) a sign of a lackluster or unprofitable company.
Major market bottoms in the Dow Jones Industrial Average have been seen when the yield on the Dow was over 6 percent. In light of the fact that a 3 percent or lower yield no longer seems to stop stock market activity to the upside (now undervaluation seems to be more in the 1 percent to 2 percent area) it might suggest to us that the 6 percent yield factor will become an even more rare occurrence than in the recent past, or may not be seen at all.
The 6 percent yield has called, without a doubt, the best major buying opportunities of the past 100 and some years. That is a long-term track record that I don’t want to neglect. Nonetheless I am concerned that we may not see such a high yield at the next market low. There have been lows without such a high yield. An absolute fixed rule of investments is that anytime the yield on the Dow Jones Industrial Average exceeds 6 percent one should mortgage the house, scrape up all the possible cash one can acquire, and buy stocks. They may not go up the next day or the next week but there is a gargantuan bull market ahead whenever stocks have had such a high yield. This has hardly ever occurred but the few instances have always led to huge stock market rallies.
The spread between competing yields of stock and bonds is probably the best way to look at these value numbers. Stocks always compete against another investment. So if stocks yield 6 percent but bonds yield 12 percent, clearly stocks are overvalued despite a high yield. In the markets all things are relative.
It makes sense to me that if we can double the yield in the Dow from a prior market high then we are in an area that we can call relative value.
Suppose the current yield on the Dow Jones Industrial Average has been 3 percent at the market top. If we were to double that we would get a 6 percent yield, at which point one would look for a market bottom based on value. That has been the general relationship of high yields to low yields in the past. A yield below 3 percent seemed to cause market highs; over 6 percent market lows.
On July 31, 2001, the yield on the Dow Jones Industrial Average was 1.69. Doubling that would be a yield of 3.3 percent. This ought to be the general area where we would next see a market undervaluation point occur. A yield somewhere in the area of 3.5 and 4.0 percent yield would most likely signal the next market bottom area. This would indeed be the highest yield for the past 20 years! The Dow had not been at such a valuation level since 1982. Accordingly, I suspected that if we again got this type of high-yield performance by the Dow it would attract long-term investors. After all, bank accounts currently are yielding about that, yet offer no opportunity for upside appreciation.
