For the past four years I have been asking: “Why do so many investors want to own a bond that pays 2% when they could own a basket of blue-chip stocks with a dividend yield of over 3% AND the dividend stream is growing 10% per year AND dividends are taxed at a lower rate than interest income?” Two answers:
- They preferred bonds because they were just plain scared by (take your pick), the U.S. financial crisis, the European financial crisis, the slowdown in China, worldwide deflation, Barack Obama, fiscal cliffs.
- Bond yields were falling and prices rising, so they could make good money in bonds even though there were overvalued.
Back to the Future?
Now the psychology is starting to change, because macro-disasters have not materialized and bond yields are rising. The market senses that, with rates so low and dividends set to keep growing, investors could decide that stocks deserve a materially higher valuation despite slow economic growth, recession in Europe, Barack Obama in the White House, etc.
That’s what occurred in the mid-1980s. The bull market started in August 1982, with stocks soaring 50% from June 1982 to June 1983. But then the Fed started to tighten and investors worried economic growth would reignite inflation. So stocks were flat for eighteen months, until the end of 1984. At that point the economy slowed, inflation stayed low, and investors concluded we were not returning to the bad old days of double-digit CPI’s and single-digit PEs. Over the next two years stocks rose 45% even though profits were terrible, declining 5% in 1985 and rising just 1% in 1986. The S&P 500 trailing PE on pro forma EPS rose from 9.8x at year-end 1984 to 14.8x at year-end 1986. (Admittedly the PE was boosted by abnormally weak profits in 1986, when oil prices and oil company profits collapsed.)
S&P 1864? I’ll Take It
We don’t need a huge five point rise in PE’s to get some pretty nifty gains in stock prices. Suppose profits are $107 this year and rise just 6% in 2014 to $113. Stocks now trade at a trailing PE of 14.4x, based on 2012 EPS of $103. If by year-end 2014 the trailing PE is 16.5x, the price would be 1864 (16.5 x 113), 26% above today’s price. A PE of 16.5x is not at all implausible if investor confidence in equities improves and bonds no longer look to be a one-way bet; the average PE in 2005 and 2006, when interest rates were much higher than now, was 16.3x.
The Dividend Driver
With investors thirsting for yield, a key driver of this PE expansion would be rapid dividend growth as profits grow slowly but the dividend payout ratio rises toward 35%, which would still be far below the payout ratios in Europe today or in the U.S. in the past. (The 1985-94 average was 48%.) Last year dividends were $31.24, or 31.2% of profits of $103. At a current price of $1480 stocks yield 2.1% on that $31.24 DPS. If profits are $113 in 2014 and the payout ratio rises to 34%, dividends would be $38.42. If the yield on the market remained at today’s 2.1%, the price of the S&P 500 would be 38.42 / .021 = 1830, 24% above where we are now.
Risks
This scenario is hypothetical and unscientific, but perfectly plausible. Just as investors became less fearful of inflation in 1985 and 1986, they may become less fearful of deflation now, driving PE ratios higher despite mediocre near-term profit growth. Even modest PE growth combined with modest profit growth can produce impressive stock price increases.
Probably the biggest risk to this scenario is renewed crisis in Europe; financial, political, and media elites cannot paper over the dire condition of the real economy forever. Eventually unemployed workers in Spain, Italy and France may bite back. Perversely, Draghi’s accommodative stance has taken pressure off governments to make structural reforms. Another non-trivial risk is that Obama’s reckless fiscal policy overwhelms Bernanke’s bond-buying spree, undermining confidence in U.S. debt.
Copyright 2013 Thomas Doerflinger. All Rights Reserved.
