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Dividend Discount Model vs. Capital Asset Pricing Model

The vast majority of investment research supports the theory that proper asset allocation is more optimal for a portfolio than market timing. Attempting to value securities may be a fruitless task, however two models that have been used to determine intrinsic stock values are the dividend discount model and capital asset pricing model.

The dividend discount model (DDM) values equities based upon future dividend payments and discounting them to the present value. The DDM is most useful for dividend paying companies, however one glitch in the model is the prediction of future dividend payments. Regardless of skill and resources, it is nearly impossible to determine dividend payments of a firm due to a variety of risk factors, such as macroeconomic risk, industry risk and high inflation. The DDM is obsolete for the vast majority of individual equities. Utilizing the DDM for blue chip firms that have paid consistent dividends for many years may assist in determining the intrinsic value of a security.

The capital asset pricing model (CAPM) is considered more modern than the DDM and factors in market risk.  The value of a security in the CAPM is determined by the risk free rate (most likely a government bond) plus the volatility of a security multiplied by the market risk premium. This model stresses that investors who choose to purchase assets with higher volatility should be compensated with higher returns than investors who purchase less risky assets. This model is consistent with statistics that prove more volatile equities, such as small cap stocks have outperformed less volatile equities, such as large cap stock over many years. Please keep in mind that time horizon, liquidity needs and risk tolerance should be factored in when determining how to invest your assets.

Although the CAPM and DDM may potentially provide an estimate of a security’s price, research proves time and time again that valuing equities based upon future assumptions is not realistic.  A disciplined approach to investing based on asset allocation should prove more beneficial for your portfolio in the long run.

Please contact Mitlin Financial Inc. if you are concerned about your current portfolio allocation.


Disclaimer: This article represents the opinion of Mitlin Financial Inc. It should not be construed as providing investment, legal and/or tax advice.

Common Stock & Preferred Stock

Investors that are looking to purchase shares of ownership in a corporation may have the ability to select either common or preferred shares.  Common and preferred stock share some similarities, however preferred shares combine many features of common stock and fixed income.

Common stock is by far the most traded type of equity in the market. The main features of common stock are that shareholders have voting rights on corporate objectives and have the ability to increase the value of their holding through capital appreciation. Shareholders may also receive dividend payments from the corporation. The downside to owning common stock, or ordinary shares, is in the case of bankruptcy. If a corporation were to file for bankruptcy and begin liquidating, owners of common stock receive funds only after debt holders and owners of preferred stock have been compensated. Due to the low level of priority in bankruptcy proceedings, the opportunity for shareholders to receive funds is fairly low.
                
As stated earlier, preferred stock combines features of both fixed income and common stock. Owners of preferred stock have preference over common shareholders in the case of dividend distribution.  In many cases, preferred shareholders receive fixed dividend payments (similar to interest from bonds). In addition to the opportunity for fixed dividend payments, preferred shareholders may also experience capital appreciation in their holding. An added feature for owners of preferred stock occurs in the case of owning shares that are convertible to common stock.  Convertible shares allow owners the flexibility to convert their shares of preferred stock for common stock if the opportunity for significant capital appreciation is more appealing than a fixed income stream. Some disadvantages of holding preferred stock are that owners do not have voting rights for corporate objectives and there may be less opportunity for capital appreciation compared to common shareholders.
                
While most investors prioritize common stock over preferred, owners of preferred stock have the ability to generate a consistent revenue stream with dividend payments as well as the opportunity to convert to common shares if capital appreciation becomes appealing.

Please contact Mitlin Financial in order to discuss advantages and disadvantages of owning preferred stock in your portfolio.

 

Disclaimer: This article represents the opinion of Mitlin Financial Inc. It should not be construed as providing investment, legal and/or tax advice.

What caused the Stock Market Crash of 1929?

The stock market crash in 1929 marked the beginning of the Great Depression, which lasted nearly 10 years through the 1930’s. Equity values plunged in the Dow Jones Industrial Average (DJIA) nearly 90% from 1929-1932, evaporating significant wealth. Many reasons can be attributed to the market crash, however the speculative bubble formed during the 1920’s and panic selling were the main factors that led to the meltdown.

During the 1920’s, the Dow increased roughly five fold in value over a nine year span due to irrational exuberance in the equity market and easy credit which led to investors buying on margin. After World War I, the stock market offered a way for individuals to create wealth for themselves. This led to equity in-flows that were never seen before. Due to the sudden rise in equity values, more retail investors invested money into the market, thus creating an even sharper stock market increase. In this time period, investors only had to put down roughly 20% of the value in equity shares and could borrow the rest on margin (lenders included banks and other investors).  The combination of irrational exuberance by investors that believed the stock market would rise infinitely and easy credit led to a speculative bubble that required a correction.

On March 25, 1929, a mini crash occurred in the stock market due to a slow down of the U.S. economy, foreshadowing what was to come in October. After the mini crash in March, National City Bank provided $25MM in credit to halt the slide and keep investors in the market in order to prevent a major selloff. Over the next few months, the American economy began showing more signs of slowing. Steel production, construction and auto sales all began to show a slowdown. Poor economic news and the debate of the controversial Smoot-Hawley Tariff Act in Congress led to the bubble bursting on Thursday, October 24th, 1929. Black Thursday, as it is now known, saw a selloff of 11% at the opening bell on heavy volume. Once the vast majority of investors heard of the market downturn over the weekend, the DJIA dropped 13% on Monday, October 28th and another 12% on Tuesday, October 29th due to panic selling from investors who wanted to get out of the market before they lost more of their wealth. Investors who purchased a high percentage of securities on margin also fled the market in order to cover potentially high margin calls. To quantify the dramatic loss in value, the DJIA went from a high of 381 on September 3, 1929 to a low of 41.22 on July 8, 1932.

Due to the speculative bubble of the 1920’s and subsequent burst that led to the Great Depression, several regulations were put into place, such as the creation of the Glass-Steagall Act (which was repealed in 1998) and the halt of trading in the event of an unusual selloff due to high trade volume. The severity of the market crash in 1929 was felt for years, as the DJIA high on September 3, 1929 was not reached again until November 23, 1954. Due to the regulations enforced after the stock market crash in 1929, it is highly unlikely that an event of that magnitude will repeat itself.


Disclaimer: This article represents the opinion of Mitlin Financial Inc. It should not be construed as providing investment, legal and/or tax advice.

Labor Participation Rate vs. Unemployment Rate

The Federal government releases its job report monthly. Following the release of this number, the market will react upon whether or not the number of jobs added was above or below expectations. Another number that generates attention from investors is the unemployment rate. This rate has steadily decreased over the past few years. The unemployment rate measures the percentage of individuals that are unemployed (and actively searching) divided by the entire labor force. This calculation should be met with some skepticism.  The unemployment rate does not take into account individuals who have ceased looking for employment. Theoretically the rate can go down because many people simply stop looking for new employment, even if no jobs were added in the United States. The labor participation may be a more accurate measure of job growth in the U.S., since it is calculated by employment divided by population (this takes into account all citizens of working age instead of leaving out those who stopped looking for employment).

In recent years, the participation rate and the unemployment rate have given conflicting results about the state of the job market. During the recent recession, the unemployment rate peaked at a high of 10.1% in October 2009, but has settled to 7.3% as of the latest jobs report. On the other hand, the labor participation rate at the beginning of the recession was roughly 66%. That number has steadily fallen to 62.8%, the lowest number in 35 years. It is worth noting that the labor participation rate has decreased consistently since the dot-com bubble burst. The differing results of the unemployment rate vs. labor participation have many investors confused as to which rate they should lend more credence to. Should individuals who stop looking for a job be counted in the labor force or should we include the entire working population? Depending on which rate you choose to believe is the more accurate representation, the job market is either gaining momentum or going on a downward trend.


Many reasons can explain the decrease in the labor participation rate, whether it is technological innovation leading to higher efficiency (and less of a need for more employees) or the job market is simply getting weaker. Please contact Mitlin Financial for a review of your portfolio and how these economic factors may be impacting you.


Disclaimer: This article represents the opinion of Mitlin Financial Inc. It should not be construed as providing investment, legal and/or tax advice.

Glass-Steagall Act

After the stock market crash of 1929 and subsequent bank run that led to the Great Depression, Congress wanted to eliminate the potential for another financial disaster. In order to mitigate future bank runs and crises, the Banking Act (known as the Glass-Steagall Act) was passed in 1933.

The Glass-Steagall Act had two main provisions; the creation of FDIC and the separation of commercial and investment banking. The Federal Deposit Insurance Corporation guaranteed bank deposits up to a certain amount. This alleviated the fear that depositors may feel during a banking crisis and potentially eliminate the catastrophic effects of a bank run.  The separation of commercial and investment banking was notable because banks were no longer able to invest savings deposits into anything other than government bonds. Any investments in securities or other speculative holdings could not be made using savings deposits. This provision in the Glass-Steagall Act prevented banks from insolvency.  Investing deposits into risky securities during a market crash could put a bank in a bind if the value of the securities can no longer cover withdrawals during a run on the bank.

While there were recessions and difficult economic periods after the Glass-Steagall Act was passed, one can argue that this legislation prevented another event like the Great Depression. Over time, certain parts of the Act and clever financial products gave banks more leniency when it came to using savings deposits as leverage for investments. Eventually, the Glass-Steagall Act was repealed during the Clinton Administration and replaced with the Gramm-Leach-Bliley Act, which allowed for the consolidation of investment banks, commercial banks and insurance companies.

One can argue that the financial recession of the late 2000’s occurred partially due to the repeal of the Glass-Steagall Act. The Gramm-Leach-Bliley Act led to the rise of comprehensive banks that utilized deposits as leverage for investing in mortgage-backed securities and other complex financial instruments. Once the housing bubble burst, the value of these securities was less than the amount of deposits in some banks, leading to insolvency and subsequent federal bail outs.

The late 2000’s recession was a complex event that was caused by many legislative events and a Federal push to make it easier to own a home.  Had the Glass-Steagall Act been in place prior to the burst of the housing bubble, the effects of the recession may have been somewhat mitigated.

Please contact Mitlin Financial with any financial questions or if you would like more information regarding the Glass-Steagall Act.

Disclaimer: This article represents the opinion of Mitlin Financial Inc. It should not be construed as providing investment, legal and/or tax advice.

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