US equities in peril; dividends slashed!

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The Federal Reserve national flow of funds accounts for Q4 2005 confirm a remarkable and disturbing new trend in corporate behavior that seriously undermines the intrinsic value of the US stock market.

Cash dividends are slashed ... will the market notice?

Over the last five quarters, the annual rate of dividends paid by US non-financial corporations has fallen by two-thirds, from $462.2 billion to $160.5 billion.

See flow of funds table F 213.

The apparent reason for this negative trend is the intent of corporate management to radically increase stock buybacks in order to boost the value of executive options.

John Burr Williams’ equations

The discounted cash flow basis for stock valuation, which has been accepted by serious analysts since the 1930s, defines the intrinsic value of equities as a function of the projected rate of growth of cash dividends, in accordance with John Burr Williams’ equations.

Now we have a situation in which the rate of growth of dividends is negative, and this is not a fluke occurrence in a single quarter, but a real trend that seems likely to continue.

Furthermore, the reduction in dividends has not been to reinvest in the company in the immediate term, with the objective of increasing future dividends.

Rather, the purpose has been solely to divert corporate profits into the pockets of executive managers by manipulating prices upwards in spot markets to give value to stock options.

See: Essays on Stock Buybacks.

Warning signals for equity investors

The flow of funds accounts are now sounding alarm bells which any serious investor should consider:

• In terms of price-earnings ratios, the stock market is well above the historical average of 15 times earnings.
• In terms of dividend yields relative to bond yields, the stock market continues to be overvalued.
• Now, in terms of discounted cash flows, with the newly emerging negative trend in dividends, the intrinsic value of equities is seriously impaired.
• In 2005, net corporate buybacks reached an all time record of $366 billion, but despite this massive attempt to jack up prices, the market rose only about 3%.
• Long-term interest rates are being pressured upwards by economic recovery and the Federal Reserve, which means that the intrinsic value of equities, based on discounted cash flows should fall further.
• Mutual fund sales, one of the pillars supporting stock prices, fell to a 3-year low in 2005.

Although no one can foresee the future, these signals should awaken those whose future depends upon a broad portfolio of US equities.

Signs of deteriorating intrinsic value may take years to be reflected in security prices.