What do frightened investors caught in the midst of the global economic meltdown do next? Warren Buffett and Anthony Bolton, arguably America’s and Britain’s most revered long-term investors, are urging us to buy Tesco, BP, GlaxoSmithKline and other “resilient quality” companies. Driven by fear and greed, investors want to believe them. But let’s take a cold, analytical look at the numbers.

The majority of the wealth accumulated from investing in UK equities comes from the reinvestment of dividends, not from capital gains. Given this, it is surprising that the many commentaries on the state of the British market pay so little attention to dividends, placing more emphasis on earnings or share prices during previous bear markets.

Historical patterns of dividend changes might be a more useful guide to what will happen next. Every year, Barclays Capital produces its Equity Gilt Study, which provides an inflation-adjusted equity income (dividend) index. We have used this to look at what happened to dividends for the ten years after the onset of three recessionary periods (1929, 1972-73 and 1989) and to estimate what will happen in 2009 and beyond.

After ten years, we assume that dividends will return to their average rate of long-run real growth (by real, we mean above inflation). We have also assumed that investors expect a real return on equities in the future similar to that they have received over the past 100 years.

Only under the 1989 scenario – with some optimistic assumptions about future growth – does the market look as if it is fairly valued.

If, as may be possible, the measures being adopted by the Bank of England and the Treasury at present lead to persistent inflation, then the 1970s may be a better guide to what to expect. Unfortunately, if that happens, the fair value of the FTSE 100 looks more like 3,000 to 3,300 points than its present level of about 4,300. Somewhere between these two is the 1929 scenario, which would suggest that fair value lies between 3,600 and 3,900 points.

Yet, importantly, not one of these calculations suggests that equities are now “incredible value” or at the “best prices for a generation”, to quote some of the more bullish recent comments.

It is true that past recessions produce different estimates as we change the interval over which we estimate dividends – if we lengthen this period the 1970s’ outcome becomes a little better as we pick up the stronger dividend growth experienced in the mid1980s – but although the individual cases produce varying results, we never see fair value exceeding the present value of the FTSE 100. And if one adopts the Robert Peston perspective – “This is a downturn like none we’ve seen since the Second World War, for two reasons: it’s global; and its primary cause is the pricking of a massive debt bubble” – then 1929 may be the best of all guides to future dividend patterns. Such a scenario suggests that the FTSE 100 has further to fall, although even embedding some of these gloomier assumptions fails to take the estimated value to much less than 3,100.

So why does the future for equities look so disappointing? There are two clues in the historical data. First, once dividends start to fall it can take a surprisingly long time for them to regain their previous levels. For example, it took until 1985 for the Barclays Capital real dividend index to regain the level that it had in 1972. Second, the average rate of dividend growth over the long term is extremely low. Figures vary, but the Barclays’ data shows no real growth since 1900 – which suggests that future growth in dividends is likely to be modest. In our worst-case scenario, 15 years from now investors will still be receiving lower dividends than they received last year.

The dividend numbers tell us that the index has further to fall and history suggests that many companies are going to cut their dividend by more than the market is anticipating. This suggests that the smart investor sits it out and waits for the bottom of the market or trawls the research for absolutely rock solid dividends.

Alan Gregory is Professor of Corporate Finance and director of the Xfi Centre for Finance and Investment at the University of Exeter Business School; Jamie Stevenson is a Teaching Fellow at University of Exeter Business School and a former head of research for Dresdner Kleinwort

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