This time it is different. Don’t count on it!

May 15, 2013

Many developed stock markets are now nearing their five-year highs. The US is now trading at all-time highs. Even the FTSE 100 is within striking distance of its 6930 all-time high, reached just before New Year’s Eve in 1999. Remember the dotcom crash that followed shortly afterwards?

In the main, London share prices have now returned to levels last seen before the credit crisis. Yet, corporate profits are generally speaking stagnant.

What’s going on?

According to FT columnist John Authers, this morning, investors are increasingly willing to pay more for a given level of earnings. “Price / earnings multiples have gone from 12 to 16 in the process” while, since September 2011, “global earnings per share have been flat.”

At first sight this kind of behaviour would suggest that investors are feeling more confident about the future than for some time, and that they expect earnings growth to improve substantially . . . soon.

Otherwise why would investors be willing to pay an apparently high(er) price for today’s earnings?

However, while profit margins are already at record levels, clearly, something else, i.e. something not profits related, is driving share prices up.

If it is not a major (expected) change in profits that drives share price up, than perhaps it is the change in the amount of money being pumped into the system.

Clearly, when central banks pump liquidity into the markets on a regular basis, as the Fed, BOE, ECB and most recently the Japanese Central Bank are doing… share prices rise faster than profits.

When central bank policy is loose, i.e. an environment with low interest rates, profit margins are expanding (because people are buying more) and share prices go up. When the central banks are tightening, with interest rates going up, people stop buying as much, and earnings go down as are share prices.

Also, due to the rather weak state of the ‘real’ economy, it is fascinating that companies would rather prefer to buy their own shares, than borrow money to buy rivals. Currently companies can borrow extremely cheaply by issuing bonds. So, it is no surprise that many companies are buying their own shares back with borrowed money, or for them to pay special dividends in order to keep existing shareholders happy.

In short, for as long as the printing presses are up and running, and both interest rates and inflation remain relatively low, stock markets are likely to remain at these elevated levels if not go (much?) higher.

However, the really bad news is that increasingly higher share prices leave less room for disappointment, from any quarter. Once central banks pull the plug, lowering, or, worse altogether, stopping the amount of money printing, share prices will come plunging down regardless of the state of their profits. This is the major risk that all ‘Johnny-come-late’ investors are currently facing.

What to do?

The best way for ‘risk-averse’ long-term income investors to deal with the current situation is only to buy high quality dividend paying shares when they are historically undervalued. In the meantime, you rake in your dividends, adding to your cash reserves. Keeping your powder dry.

Importantly, refrain from buying shares that are nearing or already are trading at historically overvalued levels as per our proprietary value/yield valuation methodology.

Crash proofing your portfolio

If and when the market crash happens do you know what to do and what and when to buy?

What is currently expensive will eventually get cheap; cheap shares will eventually get expensive, and vice versa. So if you buy now when a dividend paying shares is becoming increasingly expensive, you are more than likely to generate disappointing results in the long run.

The big threat now is that investors are increasingly willing to pay a premium for dividend paying shares. Of course that will change one day, when shares will crash. That is why I am currently rather cash rich in my own Dividend Income Portfolio.

If you are looking for a good source of information on when a high quality dividend paying share is historically undervalued or overvalued, you should consider becoming a subscriber of Dividend Income

We focus on high-yielding, reliable dividend payers, and purchase them when they are historically undervalued. Once we believe their dividends have become unsustainable, or when they have become historically overvalued, we sell.

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