Dividends – How to Combine Reliable Income and Capital Gains

Stock markets have stabilised over the last few days after a couple of big drops on Wall Street. America’s earnings season is turning into a disappointment. We’re not sure what that means, because you can only be disappointed in something you don’t expect to be so bad. The real question is what you expected in the first place.

The same goes for your portfolio’s performance. Some people would look at the stock market and say ‘whoopee, my shares are up 100% since the lows of 2009’. Others would be disappointed their shares aren’t worth more than they were seven years ago.

If you’re sick of the way your results can be spun any way your financial advisor and broker like, we’ve got an alternative for you below. But first, what’s our perspective on where you stand with your shares?

Yesterday we showed Greg Canavan our chart of America’s sideways moving stock market.

America’s S&P500 Index Going Nowhere Since 1996

Source: Yahoo Finance


‘A 16 year sideways going market,’ we told him as he stretched his calf muscles next to his desk. The answer was typical Greg: ‘I’ll show you a 100 year sideways moving market!’

Sure enough, we found this:

Source: pricedingold.com


That’s the same stock market index as above, but priced in gold, and going right back to 1880. If you’re confused, think of it like this: How many grams of gold does it take to ‘buy’ the shares in the S&P 500?

Each time the line falls, the gold price is rising relative to the stock market. Each time the line rises, the stock market is rising relative to the gold price. Over time, the stock market has a habit of returning to a gold price of around 10 grams.

As you can tell by the labels we’ve stuck on the chart, each time the stock market takes off in terms of gold, it’s a sign of trouble in the making. But it’s not that simple. In fact, this chart tells you three of the most important lessons about stock market investing:

  1. Stock market crashes are really part of sideways moving markets
  2. Capital gains are an illusion over the long run
  3. Dividends are the real source of stock market returns

If you combine those three ideas, you’re onto a winning investment strategy. More on that in a moment. But why is gold even relevant here? It’s easiest to understand if you think of gold as real money.

The price of gold relative to other things has a habit of staying constant over long periods of time. That means that if the price of something in terms of gold gets out of whack, it’s likely to return to normal levels. The chart shows this is true for shares.

So if share prices rise faster than gold, either gold is about to catch up or shares are about to fall. What usually happens, as you might have guessed from point number 1 above, is that shares move sideways until gold catches up.

That can involve the occasional stock market crash and the occasional stock market rally, but it’s sideways on the whole. That’s what happened over the last 16 years in America. Gold has been catching up while shares have been in a holding pattern.

It was a similar story during the Great Depression by the way, but the government confiscated American citizens’ gold, so you couldn’t protect yourself that way.

If you knew all this about gold and saw how far out of whack the stock exchange was with the gold price in 2000, you would have bought gold and sold stocks. That’s just what you would have read in the Markets and Money back then.

It was our founder, Bill Bonner’s, ‘trade of the decade’ in the American Markets and Money. Because Australian shares tend to follow the American market, Australians could have profited the same way.

So what is the chart telling you about today?

Well, the stock market is still overpriced in terms of gold. It hasn’t reached the low levels it usually does after a big stock market boom. That means gold should continue rising, or the stock market should fall.

That’s one way to interpret the information in the chart. But there’s a much better way to profit than trading that information. One that works regardless of where in the chart you are.

Combining Income and Capital Gains Using Dividends

As you can tell from the chart, over the long term, the price of shares don’t really rise more than the price of gold. Each time stocks take off, it’s only a matter of time before gold catches up or stocks fall back again.

That’s why capital gains are a fool’s game unless you are good at picking winners and avoiding losers. The whole ‘buy and hold’ story is a dangerous idea that only looks plausible during boom times. You might as well keep your wealth in gold.

But gold doesn’t pay an income. Some shares do, in the form of dividends. And that’s what our gold chart doesn’t take into account. How much cash could you have received in dividends from your shares over the last 130 years?

The idea that dividends are the true source of stock market returns is intuitive. Just think of shares as a small business instead of an investment asset. Small business owners live off the income their business generates.

Even if you sell the small business, how much people are willing to pay to buy it depends on the income it provides. Treating your shares in the same way will lead to proper profits from the stock market. You will get paid a regular dividend income rather than a capital gain.

Best of all, it doesn’t really matter what share prices are doing if you’re focused on dividends. Market prices don’t determine your returns. You won’t be gambling on share prices, you’ll be getting a share of the company’s profits instead.

When you retire, that means you won’t have to sell your assets. You can live off the income they provide. If you’ve managed to grow your dividends to the point where they cover your expenses, you’ll never run out of money in retirement. That’s a great way to make your golden years financially sound.

Of course, you may want to sell your shares one day. The next time stocks go soaring in terms of gold, for example. By owning dividend paying shares, you won’t miss out on this opportunity. Just keep an eye on that gold chart and sell out when things get out of whack.

Until next week,

Nickolai Hubble.
Markets and Money Weekend Edition

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Nick Hubble
Nick Hubble is a feature editor of Markets and Money and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about Markets and Money, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails.

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