Sunday, October 22, 2017

An Increasing Dividend Payout Ratio Is A Positive Indicator For The Market

Admittedly, in an equity market run investors are currently experiencing, i.e., the second longest run without a 20% pullback, a common theme that continues to seep into ones thinking, including mine, is when is the market going to experience a bear market correction of 20% or more. Even a double digit pullback is a scarcity as the below chart of the S&P 500 Index shows. The last double digit pullback occurred in February of 2016.

Without including all the charts in this post, I could reference a number of valuation charts that would indicate the market, at a minimum, is stretched. One could look at the CAPE ratio, price to book ratio, price to earnings ratio, and I could go on. One thing to remember about valuation though is markets tend not to correct simply because of extended valuations.

Are there fundamental underpinnings to the current market that would suggest investors could experience higher prices ahead. Yes. An important variable we evaluate at HORAN Capital Advisors is company action around the dividend payment. In a paper written by Robert D. Arnott and Clifford S. Asness and published in the Financial Analyst Journal in 2003, Surprise! Higher Dividends = Higher Earnings Growth, they highlighted in the paper's conclusion,
"We found that the empirical facts conform to a world in which managers possess private information that causes them to pay out a large share of earnings when they are optimistic that dividend cuts will not be necessary and to pay out a small share when they are pessimistic, perhaps so that they can be confident of maintaining the dividend payouts."
Since the end of the financial crisis, the dividend payout ratio has been on the rise and now exceeds the pre-financial crisis level. Companies are broadly optimistic about the future.

In a recent report released by S&P Dow Jones Indices they highlight the increased growth in dividend activity,
  • "within the S&P 500, the average dividend increase for Q3 2017 was 14.4%, up from 10.5% for Q2 2017 and 10.1% for Q3 2016. The median increase was 9.8%, up from 8.2% for Q2 2017 and 8.1% for Q3 2016."
  • “Q3 2017 dividend payments for the S&P 500 were a record $105.4 billion, but it may be short lived as initial Q4 numbers are trending higher,” said Silverblatt. “For full-year 2017 dividends are on track to post a 7% gain, compared to a 5.6% gain for 2016, and income tax reductions could increase payments. At this point, Street estimates call for continued gains in earnings and cash flow, as well as the potential for repatriation, all of which traditionally stimulate dividend growth."
The positive outlook around dividend growth and dividend payout ratios is an indication companies are optimistic about earnings growth in the coming couple of years. Analyst are on board with this thinking as well as Thomson Reuters I/B/E/S is reporting double digit earnings growth expectations for 2017 and 2018. There is truth in the fact that stock prices follow earnings.

Certainly valuations seem to be elevated and the market is overdue for a pullback. A Fed intent on pushing rates higher and draining liquidity from the economy is also a factor we are evaluating. However, pullbacks are normal and current data is not suggestive of a recession around the corner. A pullback would not be unexpected. Also, it is appearing tax reform might, I stress might, get done before year end. If Congress can pass a tax reform bill, this too is likely to be a positive for the market. And maybe some of the market's recent advance is pricing in some of this potential good news. Absent tax reform and healthcare reform though, company actions around their dividends are suggesting a postive earnings environment in the coming years.

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