Monthly Archives: July 2015

Do dividends and capital gains really “misbehave”?


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I finished reading the truly amusing book, Misbehaving, by Richard Thaler, a couple of weeks ago (see here for my review of the book), and beyond being a highly readable book (the book of the summer, in my opinion) with many entertaining stories, there is a passage which I found particularly interesting. It is in Chapter 17, where Thaler mentions a debate that took place in October 1985 at the University of Chicago on the empirical relevance of the Modigliani-Miller (M&M) dividend irrelevance proposition.

The M&M dividend irrelevance proposition says that the value of a company is independent of dividend policy – i.e. it does not matter whether the firm decides to pay more or less dividends. The argument is based on arbitrage: an individual investor will be indifferent between receiving cash-flows as dividends or as capital gains and, moreover, he or she will be able to undo corporate decisions by creating “home-made” dividends – i.e. selling (parts of) the shares. This result was achieved without taking into account the tax structure, because once the tax structure was included it distorted the relative value of dividends and capital gains for the investor. As it happens, in the 1980s dividends and capital gains were very different taxed in the US. It is worth quoting Thaler’s passage in full:

One of the key assumptions in the Miller-Modigliani irrelevance theorem was the absence of taxes. Paying dividends would no longer be irrelevant if dividends were taxed differently than the other ways firms return money to their shareholders. And given the tax code in the United States at that time, firms should not have been paying dividends. The embarrassing fact was that most large firms did pay dividends.

The way taxes come into play is that income, including dividend income, was then taxed at rates as high as 50% or more, whereas capital gains were taxed at a rate of 25%. Furthermore, this latter tax was only paid when the capital gain was realized, that is, when the stock was sold. The effect of these tax rules was that shareholders would much rather get capital gains than dividends, at least if the shareholders were Econs […] So the puzzle was: why did firms punish their tax-paying shareholders by paying dividends? ” (p.165, italics in the original)

An early answer to this “puzzle”, based on behavioural theory, was offered in a paper by H. Shefrin and M. Statman presented at the Chicago conference. They proposed to resolve the dividend puzzle using a mixture of self-control theory (people may wish to consume just dividend income, so as to enforce themselves to preserve capital for retirement), desire to segregate (if the value of stocks goes down, the dividend gain is viewed as a “silver lining”) and regret aversion (it is not the same to consume out of just-received dividends than to consume out of the selling of shares). They made very clear throughout their paper, that they want to emphasise that the dividend-and-capital-gains equivalence may not hold even in the absence of taxes and transactions costs (the best-case scenario for M&M) due to behavioural considerations. Continue reading

Shiller, Tobin and the “This Time is Different”: Analysing the US stock market with the rule of the 0.20


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[this is the translation of a previous post]

Robert Shiller, professor of economics at Yale University (and Nobel prize winner in 2013), has published the third edition of his book Irrational Exuberance. Beyond the fact of being a very entertaining and highly advisable book, the most important thing about its publication is not the book per se, but rather the timing: the first edition was published in 2000, just before the burst of the bubble, and the second edition was published in 2005, two years before the US real estate meltdown. In both editions, Shiller warned about the unsustainability of stock market and real estate valuations, respectively, and as it happens, he was right. In this new edition he introduces the concept of new-normal boom, putting his finger especially on fixed income valuations – though he also mentions stock markets. The right timing of the two previous editions makes many analysts wonder whether we are at the gate of another financial crisis.

This post does not intend to review Shiller’s book, but rather to make a contribution to the debate about the stock market valuations of the US economy – a debate that has been raging in the blogosphere for several years. It is worth remembering that there is no similar debate in Spain (in terms of quantity and quality), although it would be highly beneficial. To understand what is at stake in the US debate, the best way is to begin with some numbers. The following graph, courtesy of Shiller,  is a good starting point. It shows the historical evolution of the S&P500 and corporate profits, both of them deflated by a consumer price index in order to improve comparability over time:

S&P 500 and corporate earnings, historical

Own elaboration

It is clear that the basic intuition ‘higher corporate profits – higher prices’ is confirmed (with some important exceptions, as in the 90s). However, it can also be seen that since the 90s stock valuations (how much one is willing to pay for a dollar of profits) have gone up notably: especially, since the Global Financial Crisis in 2007, the S&P500 in real terms has increased more than corporate profits, which has provoked the increase in many valuation metrics. What metrics? Continue reading