This stock market correction is good news for long-term investors

The media sure do love a stock market correction and this one has been labelled “Black Monday”. But while it was definitely on a Monday, was it really all that black?

In case you missed it, the Chinese stock market has crashed. Of more interest to UK investors, the FTSE 100 has fallen by as much as 12% over the last week or so, culminating in a fall of almost 5% on Monday.

The media reaction was predictable, with endless headlines of “reeling markets” in a “devastating” multi-billion pound “meltdown”.

Okay, I get it. Market corrections can be scary, but what should investors actually do?

My contention is that this correction, like most corrections, is likely to be a good investment opportunity.

Why? Because falling share prices increase the dividend yield on most shares and usually lead to higher capital gains in the future.

Market corrections lead to higher dividend yields

Dividends are a major part of the return that investors get from the stock market. The UK market returns something like 7% a year, on average, over the long term. That 7% return comes from a combination of dividend yield and dividend growth.

Over the last 30 years or so the FTSE 100 has had an average dividend yield of 3.1% and average yearly dividend growth of 6.4%. Together they have produced an underlying return of 9.5% a year.

While nobody knows how fast dividends will grow in the future, we do know that after the FTSE 100’s recent decline, its dividend yield stands at 4.1%. That’s almost a third higher than its average for the past 30 years.

If dividend growth in the future is the same as it has been in the past then today’s high dividend yield will lead to underlying returns that are a full percentage point above their historic average.

Any reinvested dividends or new money invested would achieve that higher yield and a higher rate of return precisely because the market had declined. So for those who are actively investing new money or reinvesting their dividends, this market correction is almost certainly a good thing.

One argument against this line of thinking is the dividend cut. If a company’s share price is falling then it may be because the dividend has been or is about to be cut. In that case, there would be no boost to the dividend and no boost to future returns.

That’s true, but in a market correction, the shares of just about every company fall, whether the company is about to cut its dividend or not. So if you’re investing in the market index, or if you have a widely diversified portfolio of high quality companies, the overall dividend from your portfolio is unlikely to decline by much, if at all.

If dividends don’t decline then falling share prices will definitely lead to higher dividend yields and higher returns on reinvested dividends.

Market corrections lead to higher capital gains

It may seem like an odd concept, but falling share prices are in fact likely to lead to faster share price increases in the future.

How can this be? One way to explain it is with the dividend yield.

The dividend yield on UK shares is, as I mentioned earlier, usually in the region of 3%. Sometimes it’s lower, such as in 1999 when the FTSE 100’s yield fell to 2%, and sometimes it’s higher, as it was in 2009 when the yield increased to more than 5%.

However, most of the time the dividend yield is fairly close to that 3% level which has some pretty powerful implications, such as:

  • When the market’s dividend yield is above average it is more likely to fall, and
  • When the market’s dividend yield is below average it is more likely to rise

Of course, this rise or fall in the dividend yield could occur because the dividend payments from the market rise or fall. However, most of the time the dividend from the market as a whole doesn’t decline, and when it does it’s usually just by a small amount and the decline is reversed fairly quickly.

This means any change to the market’s dividend yield is most likely going to be caused by rising and falling share prices rather than rising or falling dividend payments.

So with a market yield of 4.1%, which is quite a long way above the average of 3.1%, we can reasonably expect the FTSE 100’s yield to fall back towards that average, perhaps within the next five years or so.

We can also reasonably expect that change in yield to be driven by increasing share prices rather than falling dividends.

If those two reasonable expectations came true then the FTSE 100 would have to rise by more than 30% from where it is today. That means any cash invested at today’s lower levels (and higher yields) has a good chance of producing very respectable medium-term returns.

This shouldn’t come as a complete surprise as it’s exactly what we saw in 2003 and 2009, where falling share prices led to extremely good returns in the years after each crash.

It’s just another manic (Black) Monday

I will admit that market corrections can be stressful, especially when our media is obsessed with doing their best to create a panic.

But stressful or not, history shows that market corrections almost always lead to higher dividend yields and higher capital gains for those investors who can ride them out.

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.

11 thoughts on “This stock market correction is good news for long-term investors”

  1. hi john
    reassuring article
    to be honest the recent volatility hasn’t bothered me that much as ive read so much about the noise and the ups and downs so im mentally prepared for it.
    But what didn’t like or’ bugged me abit’ was BBCS Ben who reports the business news said , i quote “normally long term investers ignore the trouble and know long term things will come back again, but this time its different because of all this QE. Its a brave invester who puts money in the markets now”
    is he right ? if not- unless the world has changed from here on in- what a stupid thing to come out with.
    did you see it on BBC news Monday 24 th?

    1. Hi aurora, no I didn’t see that BBC comment. I would say that’s Ben’s opinion, although as you’ve quoted it it reads a bit like a statement of fact.

      There are a million experts who disagree over what will happen, but historically, over centuries, buying at lower valuations has almost always worked out well.

      So personally I’m 99% sure that lower is better, leaving 1% of uncertainty, which includes things like the world being hit by a giant asteroid.

  2. I like to think about it as a sale. 10% off your favourite high quality stocks! The higher dividends are like a bonus 🙂 I only wish I had some more spare capital to invest whilst the sale is ongoing!

    1. Hi TV, yes that’s Buffett’s favorite analogy:

      “To refer to a personal taste of mine, I’m going to buy hamburgers the rest of my life. When hamburgers go down in price, we sing the ‘Hallelujah Chorus’ in the Buffett household. When hamburgers go up in price, we weep. For most people, it’s the same with everything in life they will be buying — except stocks. When stocks go down and you can get more for your money, people don’t like them anymore.”

  3. A lot of volatility is provided by computer trading algorithms that in simple terms sell when everyone else is selling and buy when everyone else is buying. There are also hedge funds that love to spread fear amongst retail investors so they can buy shares up cheap when they are sold in a panic. I saw this comment from a good fund manager I know yesterday, talking about his reaction to a market correction :

    “In a mutual fund, my strategy was usually to buy slowly, but with ‘stink bids’ and wait for the sellers to come to me. There was no rush but I did like going in the opposite direction to the fear. This worked in almost all declines. Generally (sometimes I worked at more conservative shops) I would buy high beta stocks before stable stocks. However, there is a caveat: I was willing to take on market risk but not fundamental risk. In other words, an expensive high beta company with growing earnings and cash was fine, but a company that had a high beta because of debt or other risks was not.”

    1. HI Andrew, I would totally agree with what you’ve said. There are a lot of computer programs doing the trading which increase volatility. As far as I’m aware that’s basically what caused the 1987 crash.

      As for what the fund manager said, I’d agree with that too. Buying high quality companies with more volatile shares is an argument in favour of holding at least some portion of cyclical companies, which is why I’m not 100% defensive, unlike say the FundSmith portfolio. I prefer to have the choice of buying a few cyclical stocks that get beaten down during corrections, as long as the underlying business appears to be strong.

  4. I’m not sure that dividends are the only story.
    The ‘cover’ is a lot lower today than it’s been in the past.
    So PE is more instructive.

    In March 2009 the PE was 7.3
    As of yesterday it was 16.13
    So the market could fall 50% from here

    And yes it may rise too!

    Who knows – but your ‘capacity for risk’ on any given pot of money is the critical issue to watch

    1. Hi Paul, no you’re right, dividends are not the whole story. However, I wouldn’t ditch them in favour of earnings as earnings are even more volatile and unpredictable than dividends.

      If I was going to look at something other than dividends (and I do) then I’d look at the PE10 ratio (or CAPE ratio) and the PD10 ratio, which compare the current price against the 10-year average of earnings and dividends respectively.

      These both provide a very stable number to compare an index’s value against and have much better predictive power than either the standard PE ratio or even the dividend yield.

      By both of those measure the market is also currently trading on below average valuations, so while the market could drop by 50%, I don’t think that’s the most likely outcome.

      Having said all that, you are right about the dividend cover. It is extremely weak and I expect the FTSE 100’s dividend to begin to decline a bit over the next year or so unless things improve on the earnings side.

      And yes, if an investor doesn’t like this degree of volatility then they should probably water down their equity holdings with something less temperamental like cash or bonds.

  5. The cover for dividends is the most worrying problem. This means companies stopped investing in their businesses and that could lead to negative earnings growth.

    Macro risks are not to be excluded from this equation: slow down in the world economy due to China, high yields defaults etc.

    Policy errors could add to this environment – I said it many times: if the FED knew what happened after letting Lehman Brothers (LB) fill for bancrupcy, they would have not let LB go. In my opinion a decision to increase interest rates by FED in September could be a policy error of the same magnitude.

    Not last, behavioural investing counts, it does not matter what we think ourselves, what matters if there are more bears than bulls in the market or the other way round.

    Myself I am at 55% stocks : 35% bonds : 10% commercial property in my portfolio, the lowest in stocks I was this year. I am picking a few cheap stocks here and there but patiently.

    1. Hi Eugen, I definitely think the current low dividend cover is signalling something. It does look unsustainably low and so I expect dividends to fall rather than earnings to rise, although at the aggregate level of an index like the FTSE 100 I don’t expect dividends to fall very much. Perhaps 10% or so but that’s purely a guess.

      1. John

        We should not forget we pay a discounted value of the future earnings when we buy shares.

        If you predict earnings to fall, we need to be careful that we don’t pay too much!

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