Lessons from the Dow Jones Utilities

We get great letters. Unclemick recently asked me to look at the Dow Jones Utilities Average. It has a long history with high dividend yields.

January 11, 2006 Letters to the Editor

Here is how you can achieve a 4.0% to 4.8% (plus inflation) perpetual safe withdrawal rate.

What I Did

I located prices at Yahoo Finance. I located a graph of dividend yields at Barron’s.

Barron’s Chart with Dividend Yields

I thinned the Yahoo Finance tables to list January prices. I converted the Barron’s graph of dividend yields into table entries by hand. I multiplied dividend yields and prices to calculate (nominal) dividend amounts. I used the CPI listing from Professor Robert Shiller’s S&P500 database to convert nominal dollars into 2005 dollars.

Professor Shiller’s Web Site

I have put several relevant tables and charts into my Yahoo Briefcase inside the Dividends folder.

Yahoo Briefcase

Dividends and S&P500 Valuations

The Dow Jones Utilities Average real dividend amount is almost entirely unrelated to the earnings yield 100E10/P of the S&P500. R-squared is 0.0053.

The Dow Jones Utilities Average nominal dividend amount is almost entirely unrelated to the earnings yield 100E10/P of the S&P500. R-squared is 0.0271.

The YIELD of the Dow Jones Utilities Average has a strong, positive correlation with the earnings yield 100E10/P of the S&P500 index. The correlation is greater than 70%. (R-squared = 0.5252.)

The regression equation is:
y = 0.5479x + 1.8708 plus and minus 3%, where y is the yield of the Dow Jones Utilities Average and x is the earnings yield 100E10/P of the S&P500.

Today’s earnings yield of the S&P500 is 3.5% (approximately). At 7% (P/E10 = 14), y = 5.7% (most likely). At 10% (P/E10 = 10), y = 7.3% (most likely).

Interpretation

We can treat the dividend amounts from the Dow Jones Utilities Average as being independent of prices. Nominal dividends have grown over time. Real dividends have fallen.

Exploiting this Information

Today’s S&P500 prices are twice the typical level in terms of P/E10. They are three times the bargain level.

Judging from history, we are likely to revisit bargain prices within ten years. At the least, we are highly likely to see prices return to typical levels within the next few years.

We should be able to purchase the Dow Jones Utilities dividend income stream at one-half to one-third of today’s (real) prices.

If we park money in 2% TIPS for ten years, we still have 70% or 80% of our original principal (plus inflation) after drawing down 4.0% to 4.8% (plus inflation) each year.

We should be able to extend this income stream indefinitely by using the remaining principal to buy the Dow Jones Utilities Average. We would live off the dividends alone. We would never sell any shares.

Our risk is that the Dow Jones Utilities dividend income stream never rises to the 5.0% to 7.0% that we need to maintain (or increase) our withdrawal rate. This is possible, considering that the confidence limits are plus and minus 3%. We are very unlikely to have a problem if we keep withdrawals below 4.5% of the original balance (plus inflation).

The past failure of Dow Jones Utilities dividends to keep up with inflation is bothersome. Offsetting this: today’s yields and real dividend amounts are at their lower extremes.

Have fun.

John Walter Russell
January 20, 2006