Discounting the Dividend Effect

Long-term reversion to the mean is fully operational here. The rate of dividend payouts, as a percentage of corporate income, has already reversed the decline of the '80s and '90s. I expect that rate to ramp upward for the next several years, at least. If I'm right -- that dividend payouts are headed demonstrably higher -- then I think it's safe to say that the market hasn't yet fully discounted this partially tax-sheltered income stream.

Why not? As I've stated in prior columns, Wall Street thinks in linear terms -- not in terms of cycles. Noted bond fund manager Bill Gross fell into that trap when he predicted Dow 5000 not too long ago, as I explained in my column on the subject last fall:

The crux of Gross' argument is that stocks are too expensive at current levels to generate a high rate of return. Much of his case revolves around the low dividend yield in the market. He said, "The market needs to yield close to 3.5% before it approaches fair value, and that means Dow 5000." When valuation is appropriately low enough, he will "admit that [stocks] will outperform the bond market."

Since that Dow 5000 prediction, stocks have outperformed bonds by a wide margin. The problem is that Gross assumed that the dividend payout percentage would be static -- not that it would be at a long-term cyclical low.

Gross' argument for Dow 5000 also doesn't factor in the appeal of a partially tax-sheltered income stream -- not his fault, of course, because the legislation was not passed at the time of his prediction. Under the new dividend tax law, on a net basis, a 3.5% dividend payout is worth, after adjusting for a marginal rate of 15%, the same as a fully taxable bond yield of 4.6%. That's more than the 10-year Treasury now pays; it's about 4.2%.

Watch for Part 2 of this column, where I'll discuss how and why the change in dividend taxation has some far-reaching implications for the Nasdaq and its leading companies.

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Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor and portfolio manager of The Turnaround Fund, a no-load mutual fund. At time of publication, neither Alsin nor ACM held a position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail]. Click here to receive Arne's latest favorite stock picks from his newsletter, The Turnaround Report.