Tuesday, August 11, 2015

F.A.N.G.: The 4 Companies Driving the Stock Market

2015 has been a challenging year for investors in individual stocks. So far this year, we’ve seen the price performance of individual stocks vary much more than it had been previously.  If you haven’t been invested in the right sector or had a decent amount of your portfolio in just a few high growth stocks, it is unlikely that your portfolio has kept up with the S&P 500.

Nothing illustrates this more than the acronym FANG, which stands for the darlings of 2015: Facebook, Amazon, Netflix, and Google.  As a whole, these stocks have accounted for more than 75% of the S&P 500’s returns year-to-date.

Amazon is up 68% so far this year.  Facebook and Google are both up by 21%.  Netflix is up a staggering 153%.  These four stocks comprise just 3.5% of the S&P 500, yet have contributed 75% of its performance.  Together, they have driven the S&P 500’s total return up by 1.6%.  The S&P 500 is up by just 2.1% so far this year.

If you own individual stocks and you don’t own these four companies, your portfolio is going to have a very hard time getting close to the market’s performance.

The question that must be asked is this: If just four stocks in the S&P 500 have been doing so well, why not own these four stocks? Why not buy shares in Amazon, Facebook, Google, and Netflix?

  1. None of them pay a dividend.

An investor who puts money into a stock that doesn’t pay a dividend can only profit in one way: If someone else is willing to pay them more for their shares in the future.  

We invest in companies for which their market price growth closely follows dividend growth.  A company that pays a dividend has shown that it can create cash from its business operations and is willing to share that cash with shareholders.

A company that doesn’t pay a dividend either (1) doesn’t make money consistently enough to afford to pay a dividend (2) is growing rapidly or (3) is not shareholder friendly.

Without a dividend, a company’s stock price is based far more on speculation about future earnings.  We’ve seen over time that earnings can be volatile.  In 2008-09, earnings for the companies in the S&P 500 plunged by more than 50% with price going right along with it.

  1. They all trade for extremely high multiples.

The price-to-earnings (P/E) ratio is a quick way to see how optimistic other investors are about a stock’s future.  It tells us how much investors are willing to pay for $1 of that company’s earnings.  The current P/E for the S&P 500 is right around 18.  That means the average stock delivers $1 in earnings for every $18 the investor pays to own it.  That represents an annual return on investment of 5.6% ($1 divided by $18).

All four of these stocks are trading at extreme premiums to the rest of the market.  Facebook’s P/E is currently just under 100.  Netflix trades for a staggering 277 times earnings.  And Amazon doesn’t even have a P/E because it doesn’t have positive earnings over the past 12 months.   Google appears to be the “value” of the group trading at a price-to-earnings (P/E) ratio of 33.

The higher a P/E investors pay, the more hope they are putting in the future.  If the next few years don’t pan out like investors currently expect, a company trading at a sky high P/E can see its stock price fall dramatically.  Buying these stocks means signing up for a return on investment of:

  • $1 divided by $33 = 3% (GOOG)
  • $1 divided by $100 = 1% (FB)
  • $1 divided by $277 = 0.36% (NFLX)
  • $1 divided by negative profits = ? (AMZN)

If these companies don't have dramatically higher earnings in the future than they have today, their returns will be unattractive, to say the least.  The only way you can profit from these shares is if you can find someone to pay even more at some point in the future.

  1. Who knows what these stocks are worth?

Are these P/E ratios too high?  Maybe.  They might also be too low. No one has any idea what Facebook, Netflix, Google, or Amazon will be worth 10 years from now.  

It’s quite possible that one or more of these companies will be trading far higher than they are today.  It’s also quite possible that at least half of these companies will have been replaced by the latest and greatest technology of the day.  

What’s clear is that earnings are not the major factor underlying the current market price per share.  Instead, it’s what each investor is willing to imagine about the company’s future.

Trying to predict the future of these companies is nearly impossible. Predicting what people will pay for them is even more impossible. We believe most investors would be better off not to try, especially not with money they need to live on in retirement.

Conclusion

Wall Street is obsessed with trying to find the next “home run”.  Who is the next Netflix or Facebook?  Who is going to triple in price over the next few years?  Betting on these types of stocks is not much different than going out to the casino and plopping down money on the roulette wheel.  Your payout is big when you win, but the odds are against you over the long-term.

We find it much easier to hit “singles and doubles” investing in high-quality dividend growth stocks.  Our multiple regression tool helps us identify stocks that are 10% to 25% undervalued.  We know these companies aren’t going to blow the doors off of the market, but we do know this: The price of nearly every company in our portfolio is highly predictable based upon its future dividend payments.  

For virtually all of the companies we invest in, the dividend has predicted 80-90% of the movement of its stock price over a multi-year period.  That gives us confidence that our portfolios will continue to grow in value over the long-term.  Investors in FB, NFLX, AMZN, and GOOG can’t say the same.

NOTE: Data as of 8/7/2015

Thursday, July 23, 2015

The Stock Market & Its Master


We’re just past the midway point in 2015.  So far, stocks have had a fairly underwhelming year. The S&P 500 has returned right around 4%, which is on pace to hit the lower range of what we predicted to start the year. The Dow Jones average is only up by 1.5%.

If you break the S&P 500 down into its components, you’ll find a more sobering story.  Nearly half of all stocks are in negative territory for the year.  A full third are down by 5% or more.  As a result, the average mutual fund has underperformed the S&P 500 by roughly 3% year-to-date (source: Morningstar).

Dividend stocks have been hit especially hard.  The perfect storm of a higher U.S. dollar, modestly rising interest rates, and collapsing oil prices have all hurt dividend stocks.  Both the Dividend Achievers Index and High Dividend Yield Index have struggled to stay positive for the year.

What's a Dividend Investor To Do?

We’ve been following the same dividend growth strategy for more than 20 years.  Over those years, we’ve seen dividend stocks outperform and we’ve seen them underperform.  In recent years, dividend stocks have been in favor as investors seek to find income.  In 2015, however, they’ve been out of favor.


We periodically fine tune which rising dividend stocks are in our portfolios based upon our market outlook.  However, we have seen that over a long period of time, dividend growth stocks generated higher than average market returns with more income and less risk than the market.


The Dog & It’s Leash


To illustrate what we mean, let’s consider a dog tied to his leash.  There are times when the dog will bound ahead of its master.  The dog cannot get too far ahead, however, because the leash will eventually yank it back.  There are also times when the dog will stand still while its master walks ahead.  This can only last for so long.  Once the dog falls too far behind its owner, the leash will yank it ahead again.


The same concept applies to dividend stocks.  There are times when the price of a stock bounds ahead of its dividend, creating an overvalued situation. There are other times when the dividend pulls ahead of the stock price, creating an undervalued situation.  There are other times when the dividend and stock price are moving along with each other, creating a fairly valued situation.


Dividends are the masters of price.  Prices are not the masters of dividend. Our research shows that dividends can predict roughly 90% of the movement of stock prices over the long-term.


To find out what the future of dividend stocks looks like, all we need to do is look at what companies are doing with the dividend.  If dividend growth is weak, we can expect future stock price growth will also be weak.


Dividend Growth in 2015


In 2015, dividend growth has been anything but weak.  With a good portion of dividend hikes already in, the stocks in our portfolios have grown their dividends significantly.

  • If end-of-year projections come in like we expect, Cornerstone stocks will have grown dividends by 10.8% in 2015 compared to last year.
  • Capital Builder dividends will be up 14.7% over 2014. 
Dividend stocks haven’t been the place to be in 2015, however, that will reverse at some point in the future.  The best thing we can do during times like this is to follow the dividend.  If dividend growth continues to be strong, we know prices will eventually take care of themselves.  We can’t know how long the master will outpace the dog, but we can know that the dog must eventually catch up to its owner.

NOTE: All data current as of 7/21/2015

Monday, June 29, 2015

3 Headwinds for Dividend Stocks: Will They Continue?

This blog was written prior to today's news about Greece. Based upon everything we see thus far, the Greece situation has short-term implications, but not long-term. Investors and financial institutions have had seven years to get used to the prospects of a Greek default. Furthermore, Greece represents only 2% of the European Union, which is a fraction of the global economy. We will have more to say on this over the next few months.

Dividend investors have had a difficult time so far this year.  While the S&P 500 Index has risen 3.0% on a total return basis, the Dow Jones Dividend Index is down 2.2% and the Vanguard Dividend Achievers Index is down 0.4%.  As usual, the nay-sayers are neighing that dividend investing is dead. But whoa Nellie, there have been three disparate forces that have pulled in the reins on stocks with higher than average dividend yields:

1.       Rising long-term interest rates
2.       Sharply appreciating U.S. Dollar versus most world currencies
3.       Collapsing energy prices


In many ways, the confluence of these three forces is unusual and not likely to last.  Over the last 20 years, long-term interest rates have been negatively correlated with oil prices and oil prices have been negatively correlated with the dollar.  One or two of these economic measures would be rising in a "normal" environment, but not all three at the same time.  It would be highly unusual if these three price trends continue in the same direction for much longer.

As strange as this time has been, the result has been clear. The current trend of these three economic measures has had a negative impact on many of the most important stock market sectors for dividend investors:
  • The rise in interest rates has hit the prices of the utilities, REITs, and telecoms sectors in much the same way as it has bonds.  
  • The rise in the dollar has significantly lowered multinational companies’ earnings and dividend growth, along with their stock prices.  
  • The collapse in oil prices has sent big oil and pipeline stocks down by as much as 30%.
The only sector with higher than average dividend yields to escape the adverse prevailing forces has been the financials, whose net interest margins and profits normally improve with rising interest rates.

As dividend investors, we have been facing all three headwinds for the last six months.  The question most of us are asking is, “How much longer can the headwinds last?”

Here is our view of these trends over the short and intermediate-term trends:

Interest rates:  With Greece teetering on the edge of default, we expect money will be in a flight-to-safety over the near-term.  This will push U.S. Treasury yields lower and allow for a modest rally in interest-sensitive stocks such as utilities and REITs.  How long the rally prevails will depend on how long it takes for the markets to digest the final outcome of Greece.  Regardless, we expect long-term interest rates will slowly move higher once the crisis is over. 

Oil prices:  The supply and demand of oil is nearing equilibrium. If that is the case, oil prices may have seen their lows.  Despite their rally in recent months, they are still 40% lower than a year ago. We have difficulty believing that a rally in oil stocks is near.  The Greek tragedy is a deflationary event. If it lasts very long, we would expect oil prices to trend lower. Furthermore, we will likely see some negative surprises from those oil and pipeline companies with high debt loads.  The companies in our portfolio are of the highest quality in the industry, which means they are in better shape to handle sustained low oil prices than their peers.

U.S. Dollar:  The flight-to-safety we spoke of would benefit U.S Treasury bonds and should also push the U.S. dollar higher.  The Greece concerns may not be a long-term occurrence, but will continue to produce near-term headwinds to most big multinational companies’ earnings and dividend growth.

Our analysis of the headwinds that have held back the performances of many great dividend stocks in the first six months of the year suggests that the second half will be modestly better than the first. However, we don’t see big moves in interest rates, oil prices, or the value of the dollar.

Companies that can produce double digit earnings and dividend growth in this environment will be highly prized.  We will continue to favor higher dividend growth versus higher dividend yield in the coming months.  We particularly like companies that derive more than 60% of their earnings in the United States. These kinds of companies are not as sensitive to the movements of the dollar as are the multinational stocks.  In addition, their higher growth can trump changes in interest rates.

In addition, most of them are benefactors of lower oil prices.  As long as these companies can produce above average earnings and dividend growth, we believe investors will continue to push their stock prices higher. We'll talk about some of our favorites in future blogs.

Finally, a near-term modest fall in interest rates would seem to be a negative for the financials.  In addition, they have all experienced strong price growth year to date.  With the trouble in Greece filling the headlines, we would not be surprised to see the financials tread water for a few weeks to months.

The Greek tragedy seems to be a never ending story that will lead surely to a catastrophic ending, but investors have had five years to get out of the way of a doomsday scenario for Greece.  We doubt the effects will be long lasting.

Friday, May 15, 2015

The Great P/E Debate: Are Stocks Overvalued?

Janet Yellen made headlines last week with her comment that stock market valuations “generally are quite high.”  The market took note, driving down prices.

Is she right?  Are stocks overvalued?

It certainly feels that way to most investors.  Stocks are trading at all time highs and are in the midst of a bull market that has seen the S&P 500 move up more than 200% since mid-2009 lows.

However, investing based upon feelings isn’t usually a very good idea.  That’s why we rely so much on statistical models to help us be objective about where market valuations stand at any given point in time.  Let’s see what we can uncover.

The Average P/E Says… Stocks Overvalued


It is most likely that Yellen was referring to the price-to-earnings (P/E) ratio in her speech.  Stock market pessimists have been promoting doom-and-gloom for years now.  The #1 argument they make is that the P/E ratio is higher than its long-term average.

Below is a chart showing the S&P 500’s P/E ratio going back to 1962, as represented by the red line.  The blue line is the S&P 500’s long-term average P/E of 15.  



The current P/E of 18.5 is higher than the long-term average. Taken at face value, this would indicate that stocks are frothy.  However, this argument has several critical flaws.

1. Stocks seldom trade at average P/Es.
  

Since 1962, the S&P 500 spent virtually no time at its long-term average of 15. In many years, it traded at a P/E far from its long-term average.

2. A “fair” P/E ratio is impossible to determine in isolation.
What is a “fair” P/E ratio?  Is 15 fair?  If so, what makes it fair?  The point is that P/E ratios mean little in isolation. There are other factors that we must consider to get the entire picture.
   

The Missing Link: Inflation


What is the most important factor in determining fair P/E ratios?  We have looked at correlations between P/E ratios and all kinds of variables.  We do not find strong relationships between any of the widely followed indicators such as interest rates, GDP growth or earnings growth.  We have found that inflation is the best predictor of P/E ratios at any given point in time.

To make this more intuitive, we’ve converted the P/E ratio into E/P, which is known as the “earnings yield”.  In other words, if the S&P 500 paid out 100% of its earnings as a dividend, what would the yield be?

The chart below compares the S&P 500 earnings yield and the personal consumption deflator, which is what the Fed uses as its inflation measure.


As you can see, there is a clear visual relationship between the two.  To measure the relationship mathematically, we created the scattergram shown below.  On the left axis is earnings yield and the bottom axis is inflation. Drawn through the middle is a linear regression line.


The correlation between inflation and earnings yield is not perfect, but it is there.  Using this regression, we arrive at the formula shown in the bottom right corner.  That formula is:


y = 0.9048x + 0.0366

In the above formula, “y” represents the estimated earnings yield and “x” represents the current inflation level.  If we plug in today’s level of inflation, the formula will predict where today’s earnings yield should be based on the historical relationship between inflation and earnings yield over the past 212 quarters.

In the chart below, we’ve applied this formula to each quarter going back to 1962.  The blue line represents the “predicted” earnings yield and the red line represents what the actual earnings yield was.


Most people aren’t used to looking at charts of earnings yield, so we converted the earnings yield (E/P) back into P/E.  That chart is shown below.


The chart above clearly has more predictive power than the “average” P/E.  If you were simply following this chart, you would have predicted that stocks were about fairly valued in most periods except the following:

  • Overvalued from 1968 to 1973
  • Undervalued in 1985
  • Overvalued in 1987 (right before the market crashed by 25%)
  • Significantly overvalued from 1992 through 1994
  • Significantly overvalued from 1998 through 2001
  • Undervalued from 2009 through today

What does this mean for today’s market?


This model tells us a few things:

1. Stocks are not overvalued.

Far from it.  According to this model, the appropriate earnings yield is roughly 4.7%, which translates to a P/E just over 21. If the personal consumption deflator were to hold around 1.1%, the market would likely continue P/E expansion.

2. The stock market can handle some inflation.

The Fed has stated that their target inflation level is 2% vs. today’s 1.1%.  If inflation does rise to 2%, our formula estimates that the fair P/E would be about 18.5, which is exactly where we are now.  The stock market appears to be pricing in the expectation that inflation will rise.

3. The Fed isn’t going to wreck the stock market.

Investors across the globe are concerned that stocks will be hurt when the Fed starts to raise rates.  According to our research, however, this just isn’t the case.  Inflation is twice as correlated with P/Es as interest rates.  In our judgement, a gradually rising Fed funds rate won’t bring down the market. As long as the Fed does not aggressively raise rates, signalling that they see a significant risk to higher inflation, stocks can handle a period of rising interest rates.

The Great P/E debate will surely rage on for decades to come, but we believe many investors - including our own Fed chairwoman - have completely missed the point.  Average P/Es have no predictive ability for future P/Es without taking inflation into consideration.   

Unless inflation rises above 2%, the S&P 500 will be driven primarily by the future growth of earnings and dividends.  In this regard, there is plenty of good news.  Wall Street analysts are currently projecting double-digit growth in both earnings and dividends over the next 12 months. 

If Fed chair Janet Yellen jawbones inflation worries higher, that could derail stocks.  If she focuses her attention on containing inflation rather than forecasting stock market valuations, we would all be better served.

Tuesday, April 21, 2015

The Value of Royal Blue Chip Stocks

How do you gain the benefits of investing in stocks while minimizing the inherent risk of investing?  Enter Royal Blue chip stocks. 

Royal Blue chip stocks are one of the pillars of our Cornerstone portfolio.  They are the AA and AAA-rated companies that make products the world cannot function without.  Many of them produce billions in cash flow, which they use to consistently grow their dividends year-after-year.

Royal Blue chip stocks are not particularly exciting.  When the overall market is up 15-20% per year, we might expect the average Royal Blue chip stock to be up more like 8-10%.  In other words, owning Royal Blue chip stocks will drag down performance in a bull market like the one we’ve seen over the past 6 years.   

So why own these stocks?

Less Price Volatility

Royal Blue chip stock prices are far less volatile than the average stock.  In a bull market, this low volatility means underperforming the index.  Take Procter & Gamble (PG), for example. Since the beginning of 2013, PG's price is up 23% compared to 50% for the S&P 500.  In a bear market, however, Royal Blue chip stocks act like parachutes.  In the second half of 2008, the S&P 500 was down by over 35%.  PG, on the other hand, was down by less than 7%.

Royal Blue chip stocks are the reason our Cornerstone portfolio was down by far less than the S&P 500 in the 2008-09 financial crisis.  They aren’t exciting in bull markets, but when the inevitable bad spell hits - you are glad that you own them.

Low Business Risk

The chances that a Royal Blue chip company could go out of business is extremely slim.   Not only are they some of the most financially secure companies on Earth, but their products are staple to our lives.  These companies aren’t going away anytime soon.

Steady Dividends

Most Royal Blue chip stocks have paid and grown their dividends every year for decades.  When your portfolio contains Royal Blue chip dividend growth stocks, your portfolio continues to produce a growing stream of dividend income, regardless of what happens in the markets.

Stock prices have always been volatile. Our priorities for our clients’ portfolios are: security, income and growth - in that order.  Royal Blue chips may drag down performance in bull markets, but they will always be a pillar of our Cornerstone portfolio.  History shows us that when the next bear market comes, Royal Blue chips should outperform the broader market.

Monday, April 13, 2015

Downshifting The Industrials

In today’s Investment Policy Committee (IPC) meeting, we focused on the sector weightings in our portfolio.  Industrial stocks were of particular interest.  The industrial sector faces several headwinds at this time.

1. Interest Rates

How can low interest rates be a headwind?  Our research shows that the relative performance of the Industrial sector is positively correlated to interest rates.  The chart below shows this relationship.

As you can see, 10-Year Interest Rate Yield (blue line) and Industrials Index relative to S&P 500 (orange line) move closely together.  This may not be immediately intuitive, but the relationship does make sense. 

When interest rates rise, that generally means the economic outlook is improving.  The Industrial sector is particularly sensitive to economic movements.  Therefore, an increase in interest rates indicates an improving economy, which is positive for industrials.

We believe interest rates will remain muted.  The industrial sector could underperform over the near-term, as a result.

2. Emerging markets

Many industrial companies have made huge investments in foreign economies, particularly emerging markets.  The decline in oil prices has really put a hurt on several foreign nations, particularly Brazil.  China’s economy has also slowed, which has not been favorable for the outlook of many industrials.

3. Energy prices

Low commodity prices represent another headwind.  Oil prices do not directly impact industrials, however, many of them manufacture supplies for the energy producers.  As the investment budgets for energy companies dry up, it means less demand for their suppliers.  If oil prices remain low, the energy divisions of many industrials will also suffer.

4. Competitiveness

Currency issues impact the industrial stocks in two ways:

1. Earnings translated back into U.S. dollars are worth 20% less than they were 6 months ago.  The market can overlook that, as we will explain more in coming weeks.  

2. Industrial companies who sell to foreign nations are much less competitive when the dollar strengthens.  That hurts competitiveness of U.S. suppliers.

What does it mean for you?

We continue to like the industrial sector for the long-term, but these headwinds will not go away in the near-term.  As a result, we have decided that it is prudent to cut back your exposure to the Industrial sector until these headwinds subside.

Wednesday, April 01, 2015

Why Are Stocks So Volatile?

Stock market volatility has increased dramatically over the last six months. Many commentators are saying the increased volatility is a negative sign for stock performance through the remainder of the year and perhaps beyond.  As usual they might be right, and they might be wrong.  Before we give you our view, let’s look at what we believe are the three main drivers of the increased volatility and see how they are trending.

1. Uncertainty about the timing of the Fed rate hike
2. Earnings worries
3. Valuation concerns


The Fed: Don’t fight the Fed, don’t fight the Fed, don’t fight the Fed.  As any seasoned investor knows, these are the first three rules of investing.  The Fed has incredible power to impose its will on the markets.  Back in the days prior to the Tech wreck, commentators were saying that the Fed’s power to rein in the technology stocks was dramatically reduced because most of these companies used very little debt.  The Fed raised its Fed Funds rate seven times before Tech stocks crumbled, but crumble they did.  Again in 2009, the chorus of naysayers was deafening in its assertion that the subprime crisis was too big for the Fed.  Today the S&P 500 is approximately 300% higher than its low in March of 2009.  In our judgement, the Fed can do what it wants.  So the single most important question facing investors is, “What does the Fed want?”


We believe the Fed has no intentions of causing a big sell off in stocks. Indeed, Quantitative Easing was all about pushing investors out of riskless securities and into riskier assets, including stocks.  Why would the Fed have moved heaven and earth over the last six years to avoid a deflationary mindset from setting in with banks and investors, to toss it all away and send stocks into a tailspin?  That is an absolute recipe for recession, and they know it.   


The Fed wants to keep a lid on inflation and stimulate job growth, yet it also wants to avoid both another 1995-1999 stock market melt-up and a 2000-2002 meltdown.  Our Macro Team believes that the lessons of the 1990s are still very much alive in the minds of the Fed.  To accomplish their purposes, they are likely to do a lot of talking but very little acting.  We believe Fed Chair Janet Yellen said as much in her speech last Friday.  The uncertainty about what the Fed will do is not going away, yet we believe the odds of the Fed slamming on the brakes are extremely low.  They will increase rates modestly at some point, but we do not forecast a long string of hikes that would freeze the markets or cause a big sell off.


Earnings: Earnings growth for the S&P 500 over the last 12 months has been a paltry 4.3%.  During this same time, stock prices have risen nearly 13%.  At the beginning of 2014, we said that stocks were about fairly valued, so the returns for the year would likely be about the same as earnings and dividend growth.  A 13% price return on earnings growth of about one-third of that is front and center in the minds of every investment firm we know of.  The market has given the weak earnings a pass so far because of two unusual events:

1. The dollar has risen by as much as 20% versus the currencies of other developed countries.  Since S&P 500 companies generate nearly 50% of their revenues outside the U.S, they have had to absorb currency losses for the last four quarters.  These currency translation losses have significantly reduced reported earnings.  This trend cannot continue indefinitely.

2. The entire Energy sector took a huge earnings hit in the fourth quarter of 2014 and will again in the first quarter of 2015.   Since the Energy sector represents nearly 10% of the S&P 500, it has also produced a drag on corporate earnings.  Once oil prices reach a bottom, this too will cease to be a headwind.


The good news here, which gets almost no attention in the media, is that S&P 500 dividends increased by over 13% during the last 12 months.  We consider that an important signal that corporate America believes the two headwinds hurting earnings are temporary.


Valuation:  If prices rose in 2014 by 13% and earnings grew by only 4.3%, then the price-to-earnings (P/E) multiple expanded.  Indeed, the P/E multiple now stands at nearly 18 times earnings, which is the highest level since 2007. Stocks are not cheap from a P/E perspective, which worries a lot of investors. We have modeled P/Es going back to the 1920s and we find there is no such thing as a “normal” P/E ratio.  


Our research shows that P/Es are inversely correlated with inflation.  In high inflation periods, P/E ratios have almost always been low and high in low inflation eras.  Think of it this way:  If we divide earnings by price, we produce something called Earnings Yield.  Earnings Yield is stated as a percentage.  It is essentially a computation that shows how much a company’s earnings produce as a percentage of it price.  This percentage can then be compared to bonds, inflation, or other stocks to determine how good of a deal you are getting.  This is how an investor like Warren Buffett determines if Heinz or Kraft is a good deal.


As we said before, the S&P 500 is currently selling for about 18 times earnings.  To convert this into an Earnings Yield, we divide 18 into 1 to see that the current level is 5.5%.  That means if Warren Buffet was interested in buying the whole S&P 500, he would earn a 5.5% total annual return based on the current earnings.  5.5% does not seem like a great return, but there are two important considerations.

1. How does that return compare to my other alternatives?


While 5.5% may not seem like much, it is terrific when compared to a short list of alternatives.  A five-year U.S. Treasury bond yields 1.3%, and a ten-year U.S. Treasury bond yields about 1.9%.  Thus, not counting any earnings growth that we may receive in the future, stocks would seem to be a good deal with an earnings yield much higher than bond yields.  


As we said earlier, our work has shown that Earnings Yields or P/Es are most highly correlated with inflation.  Today, the inflation figure that the Fed uses, the Personal Consumption Expenditure Deflator (PCE) stands at 1.1%.  We have found that the spread between Earnings Yield and the PCD over the last 50 years has averaged 3.4%.  By adding the current level of inflation of 1.1% to the average spread of 3.4%, we find that the model would suggest that the right level of Earnings Yield for today’s inflation level is 4.4%.  


So we can get back to how we normally talk about earnings and prices, let’s re-convert the predicted 4.4% Earnings Yield back to a P/E ratio.  A 4.4% Earnings Yield would equate to a P/E ratio of 22.7.  With stocks currently selling at 18 times earnings, our P/E finder model would say they are  cheap.

2. Is that return all we are likely to get?


The current earnings yield of 5.5% does not factor in any future earnings growth.  If the long-term growth of earnings approximates nominal GDP growth of 5% or 6%, the effective earnings yield for today’s investor would double once every 12-14 years.


In addition to P/E, we have another way of looking at market valuations.  As we have discussed over the years, we have a S&P 500 valuation model.  This is a statistical model that calculates the relationship between various factors including dividends, earnings, inflation, and interest rates.  According to that model, we are currently selling about 7% under where year-end 2015 data for the variables are now predicted to be.


Bottom Line


Uncertainties about many different factors have caused stocks to become more volatile.  We believe we will know a lot more about Fed actions and the outlook for future earnings beginning in August once the impact of big changes in currencies and oil prices are better understood.  Furthermore, valuation is not a problem according to both our P/E finder model and statistical S&P 500 model.  

The current market’s volatility will ultimately pass.  Based upon what we see, the path of least resistance for stocks is still up.  However, it will take a few more months before many of investor concerns will subside.  The best course for investors is to ignore market volatility and remain committed to building a stream of growing dividend income.