What You Should Do If Stocks Fall Farther from Here

Though the big stock market indexes are well below their late 2007 highs, I don't expect investors will make much money in stocks on the long side from current price levels. Record dividend cuts, weak earnings, and unattractive valuations are telling you to be careful buying stocks these days. 

Most of the return in stocks over the long term arrives in shareholders' pockets in the form of dividends, not capital gains. Consistently earning big capital gains in public securities markets full of arbitrageurs and big institutions is too hard for the overwhelming majority of investors. 

Earning dividends is much easier, providing a steady source of return that only requires you to buy a stock and hold it. And this is where I'm worried... 

This year might just go down in history as the worst year ever for dividends. In the first quarter of 2009, companies cut $40.8 billion in dividends, more than were eliminated in all of 2008. 

Though I don't have dollar totals, I do know that, in the second quarter of 2009, 250 corporations reduced or completely canceled cash dividends, the worst performance since the second quarter of 1958 (during a recession), when there were 272 reductions and omissions. Only 97 companies reduced or eliminated dividends in the second quarter of 2008. 

As the primary source of return for the overwhelming majority of investors, dividends are a critical bellwether for stocks, one that routinely goes completely underappreciated by Wall Street. When dividends go away, investor returns suffer. They're going away faster than ever, so you need to be extra careful about them. 

I keep a "World Dominators" buy list in my Extreme Value advisory. It's where I believe the majority of your stock portfolio should be. This list contains the best dividend-paying stocks in the world. For instance, portfolio holding Procter & Gamble has raised its dividend every year for 53 years. ExxonMobil has done so every year for 27 years. 

But be careful, even with blue-chip stocks. For months, General Electric said its dividend was safe, then cut it by two-thirds, its first dividend cut since 1938. 

Besides dividend cuts, another important reason you should be careful buying stock is that most stocks are just too expensive compared to earnings. Stocks were cheap in March. But since then, they've risen nearly 40%. They're no longer cheap, so you shouldn't be too eager to follow the trend. 

Standard & Poor's 2009 earnings estimate for the S&P 500 is $55.61. At 882, the S&P 500 is trading around 15.9 times 2009 earnings. The index's long-term average, a reasonable proxy for its fair value, is 16 times earnings. 

To expect anything more out of stocks overall, you must make a strong case for earnings growth. That's hard to do with banks failing, unemployment pushing 10%, and the largest debt market in the world – the U.S. residential mortgage market – in the middle innings of a once-a-century meltdown. 

People who don't have jobs and can't pay mortgages spend less than people with jobs who can afford to live in their houses. With housing in charge of the economy now, more unemployment means a worse outlook for corporate earnings and stocks in general. 

Instead of expecting growth, try calibrating your expectations based on the 1970s. Do that, and you'll easily see how valuations could sink lower and stay there for a decade or more. 

Mr. Market's Bottom S&P 500 valuations through the Great Inflation (highlighted years represent bottoms)

Year	P/E
1974	7.3
1975	11.7
1976	11.0
1977	8.8
1978	8.3
1979	7.4
1980	9.1
1981	8.1
1982	10.2
1983	12.4
1984	9.9
Average P/E	9.5x

Compared to the 1970s bottoms, the March 2009 bottom, at 666.79 (12 times the 2009 S&P 500 earnings estimate), doesn't look at all like a bottom. Based on historical valuation, the ultimate bottom, the one where you buy every share you can get your hands on, could be another 39% below the March bottom. 

Not all is gloom and doom. There's some good news in that table. Notice in each year after a highlighted year how the P/E multiple expands at least 22%. Also notice that stocks remained at attractive valuations for 10 solid years. You could have bought stocks every year and made a fortune by hanging on for the long term. 

What should you do to prepare if I'm right about further market declines? Use panic selloffs (like we had in February and March) as a chance to buy World Dominating businesses like P&G and ExxonMobil. Focus on using the compounding power of dividends, rather than on the next great growth stock. 

As you can see, the next decade could be rough for the stock market. But if you stick to buying World Dominators when others are selling, there's no reason you won't make plenty of money in stocks. 

Good investing, 

Dan Ferris 

P.S. If you'd like access my World Dominators list - plus two of my favorite ways to make money from a market decline - come on board as an Extreme Value subscriber. If you have a lot of money in stocks, I think this list of companies is the single most valuable piece of information in the world. You can learn more about Extreme Value here.