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 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 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.