My targets here are those that claim that the dividends reaped in past decade would have more than made up for any capital losses and in fact the returns would still have been decent. The first question that requires answering is: Returns compared to what? The gold-standard zero-risk investment is (or at least was) US Treasuries. Since the year 1997 has been mentioned so often, I'm going to use that as my entry point here. For those that want to play along at home, you should download the SP500EPSEST.xls file from the link on the right. I'll also reference some interest rates you can find in the St. Louis Fed database also linked on the right.

Here are the starting conditions: On December 31, 1996 SPX stood at 740.74 and the interest rate on the 10-year treasury pegged in at 6.54%. Let's make some gross simplifications and a few assumptions.

1) Purchase of 1 share of SPX for 740.74

2) Purchase of 740.74 worth of 10-year treasury yielding 6.54%

3) Dividend re-investment in SPX each quarter.

This last point is done because I believe that most people - or at least most buy-and-holders - probably just do the DRIP approach with their mutual funds. So now we have two plans: SPX vs. Treasury.

So at the end of the Q1/1997, the dividends were $3.61 and SPX was 757.12. This means that 0.0048 shares were acquired for a new total of 1.0048. This was then used to acquire dividends in Q2/1997, which were paid at a rate of $3.87/share which translates to $3.89 in dividends to reinvest and acquire another 0.0044 shares with SPX at 885.14 to bring the total owned to 1.0092. And on and on and on up until today, when you would own 1.2233 shares at SPX closing value of 773.14 for a total value of $945.82.

For the years until the treasury matures, it will throw off $50.41 in interest each year until it matures. At that point, to make this comparison easier, the accrued value is re-invested in a 2-year treasury. The interest rate on the 2-year at that point (1/1/07) was 4.8%. The total of $1274.80 would be re-invested at 4.8% simple interest. This produces a total value of $1397.19.

Hmm... so I'm clearly not getting something here. All the risk of the stock market for a lower return? Now, I was not educated in finance and perhaps my math is wrong but I'm pretty sure that the risk-reward equation is supposed to reward risk with a higher return. Excel's INTRATE function produces a rate of 2.31% on the SPX investment when the same formula returns a rate of 7.38% for the Treasury plan. And to add insult to injury, the SPX investment plan doesn't even keep up with CPI inflation. Don't believe me? Click through to BLS CPI Inflation Calculator and find out for yourself. Entering in that $740.74 investment in 1997 dollars produces a value of... $974.47 in 2009 dollars for a real-dollar LOSS. Granted, the real-dollar gain in the Treasury plan isn't glamorous but at least it's a positive number.

Now, the current rates on the 1o-year are an atrocious 2.799%, so the Treasury plan isn't exactly a viable strategy going forward from here. At least barring a wave of deflation that I'm thinking most of us don't even want to ponder. However, I am extremely skeptical of people using the Q4 dividends and the tanked SPX value and producing yields in the 3's. How on earth can you make the assumption that dividends will not fall further? Have balance sheets suddenly gotten stronger in the last two months? Looking at the past work and charts on dividends that I put up, it's pretty clear that it takes quite a bit of EPS degradation to knock dividends down a significant amount. But, look close at some of the charts of reported and operating EPS on this blog and you'll see that the forecasted EPS levels for 2009 look more like 2002 levels for reported EPS and 2005 for operating EPS. A quick look at the dividends from that era show a large difference. I'm not sure this gets bridged but I'm not exactly optimistic that the current yield will be maintained.

One can argue that these are anomalous times and you'll see all sorts of people who want you to invest your money through their service telling you that this is a great time to buy stocks at their brokerage. Just remember, there are real pitfalls to the buy/hold/re-invest strategy and the simple little chart should be plenty to illustrate that.

## 1 comments:

thanks, interesting read.

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