What Has Driven U.S. Equity Returns – Is It Sustainable?
The S&P 500’s performance during the last few years has been strong, but what has underpinned that strength? Was it improving business fundamentals or higher valuations?
By most standards, the S&P 500 index’s returns over the five year period ending December 31, 2016, were spectacular. The annualized rate of return during that time was 14.6%. This return occurred during a period of low, risk-free interest rates and low inflation, making it that much more impressive.
Breaking Down the S&P 500’s Performance – A Tale of Two Valuations
Understanding what drove this return is crucial in investment planning. The two sides of return attribution are fundamentals and valuations. Equity fundamentals reflect the underlying business activity. When revenue and earnings increase, investors hope to be rewarded with a higher stock price.
On the other hand, valuations reflect the changing relationship between price and fundamentals. If valuation drove the strong performance, investors are paying more per unit of business activity today than in the past. This is often synonymous with lower future returns, which could lead to a portfolio allocation change and/or change in savings rate.
So let’s evaluate the five year stretch ending December 31, 2016. We can start with the dividend discount model, which is a tool for valuing the price of a stock. The dividend discount method uses dividend yield + dividend growth + change in price / dividend ratio.
Strong dividend growth underpins the S&P 500’s recent performance. In fact, we looked back over the past 90 years (breaking that period up into 18 independent five year periods), and found that the period ending 2016 was the second highest period in nominal dividend growth terms and was the best period in real terms. The best five year stretch was the period ending in 1951 which reflected the post-war boom. Importantly, today investors are paying only slightly more for $1.00 of dividends than five years ago. In other words, from a dividend valuation point of view, our outlook today isn’t different from five years ago even though during that period equity prices have appreciated substantially.
Another building block model is the earnings model. It is similar to the dividend discount model but replaces dividend growth with earnings growth. Also, the valuation measure is price to earnings. The earnings building block = Dividend Yield + Earnings Growth + Change in Price / Earnings Ratio.
Here we have a dramatically different story. Unlike dividend growth, fundamental earnings growth has been anemic at under 2% per year. Looking back to 1925, we find that earnings historically have grown at a nominal rate of 5.1% annually (based on data provided by Robert Shiller).
The U.S. economy has grown slowly over the last five years, this being a particularly weak economic recovery compared to others in our history. What drove investment performance was valuation, or the willingness of investors to buy shares at higher prices per unit of earnings. In fact, the P/E ratio of the S&P 500 went from 13 to 21 during that five year span (the P/E ratio is based on Standard & Poors’ trailing 12 month operating earnings).
The chart below shows that nominal earnings growth (earnings based on Generally Accepted Accounting Principles, the standard method of corporate accounting for U.S. companies) has been less than stellar, which is significantly different from dividend growth.
The bridge between the two methods of return performance attributions is the dividend payout ratio, or dividends/net income. This ratio increased significantly over the five year period and is now at the top of the historical range. Overall, this is a negative with respect to future return potential.
There is an upper limit on the amount of earnings that can be returned to shareholders versus reinvested in the business to sustain future growth. If underlying growth doesn’t pick up over the next five years, it will be difficult to repeat dividend growth of the last five years.
Are we poised for further growth as the U.S. economy continues to show strength? Or did the past five years set us up for very modest returns going forward? Let’s looks at a few more variables: revenue, GDP, cash flow etc.
Amongst a broader set of variables, the strength of dividend growth appears to be an outlier. Metrics such as earnings, revenue, free cash flow and book value have all been modest and not supportive of the price appreciation we have experienced. With this in mind, we can’t help but view the U.S. equity markets today as more richly valued than five years ago.
Segal Marco Advisors believes that return prospects for the U.S. stock market appear likely to be on the lower side of historical averages in coming years, and that investors should consider diversifying their portfolios to nudge returns in a more favorable direction.