Strategy: Dividend Discount Model. The answer to the question posed in the title is “Eventually.” Barring the end of the world as we know it, the stock market will double again some day. It always has in the past. The reason I ask this question is that one of our accounts asked the implications for stock prices if the S&P 500 dividend yield were to fall along with the bond yield. The dividend yield is currently 2.12% (Fig. 1). The 10-year Treasury bond yield fell back down below 1.50% last week (Fig. 2).
The S&P 500 would have to increase 41% to 3062 if investors push the dividend yield down to 1.50% to match the current bond yield because dividends can grow while coupons are fixed. If the bond yield fell to 1.00%, the S&P 500 would have to double to 4593 for its yield to fall as low as that.
For investors to do so, they would have to believe that the bond yield is likely to stay that low for several years in the future and that dividends will grow in a world where the bond yield is stuck at 1.00% seemingly forever. And what if dividends were to fall in this world? In that case, fixed coupons guaranteed by the US government would be much more attractive than dividend-yielding stocks.
In a 4/29 CNBC interview, Warren Buffett said: “Interest rates act on asset values like gravity works on physical matter. If you had zero interest rates and you knew you were going to have them forever, stocks should sell at, you know, 100 times earnings or 200 times earnings.” He must be assuming that earnings and dividends would still be rising in this scenario. Of course, with the S&P 500 currently trading at a P/E of 17.0, the S&P 500’s valuation wouldn’t just double but would increase six-fold to rise to a P/E of 100.
It is hard to imagine that the S&P 500 could double from here anytime soon now that it is at a bull market record high with a P/E in the high teens. Nevertheless, in this business, we always need to expect the unexpected, or at least think about it. A melt-up led by dividend-yielding stocks is possible. In fact, Joe and I still give this scenario a 30% subjective probability. We are still at 10% for a melt-down scenario. The remaining 60% we assign to a long and leisurely secular bull market as the global economy continues to grow at a subpar pace with neither a boom nor a bust, a.k.a. the “secular stagnation scenario.” That would put the S&P 500 between 2300 and 2400 next year, in our opinion.
Keep in mind that from 1998 to 2002, investors were willing to pay over 20 times forward earnings for the S&P 500, with the index’s Technology sector trading as high as 48 in March 2000. Especially overvalued were tech companies that paid no dividends and reinvested their cash flow in their own growth or acquired other tech companies that were deemed to provide synergies and more high-octane earnings growth. The dividend discount model for valuing stocks was irrelevant as investors focused on earnings. Earnings were often inflated through various accounting gimmicks, including the exclusion of stock compensation in expenses.
Now investors seem to be willing to pay a significant premium for dividend-yielding stocks, and even tech companies have started paying dividends in recent years. If this trend continues, we might all start using the Dividend Discount Model (DDM) again, which values a stock by dividing its dividend per share by the difference between the discount rate and the growth rate of the dividend. Factoring in dividend growth could certainly justify Buffett’s pie-in-the-sky valuations if interest rates remain this low “forever.”
In recent conversations with our accounts, I’m hearing more of them concluding that while P/Es are awfully high for dividend-yielding stocks by historical standards, record-low interest rates around the world might justify still higher valuations for these stocks. I’m hard-pressed to disagree. Again, it all depends on whether the bond yield can stay this low while the economy continues to grow, albeit at a subpar pace as long as there is no recession for a long while. Debbie and I think that’s a possible scenario. Now consider the following relevant recent developments:
(1) Bond yields. Two weeks ago, the bond yield briefly rose slightly above 1.50% as the Citigroup Economic Surprise Index (CESI) soared from the year’s low of -55.7 on February 5 to a recent high of 43.1 on July 26 (Fig. 3). But last week on Wednesday, the report of June’s durable goods orders came in surprisingly weak, at a 4.0% decline, and so did Q2’s real GDP gain of just 1.2% (saar), reported on Friday. The CESI dropped back down to 16.3 on Friday. In addition, on Wednesday of last week, the FOMC statement suggested that the Fed was in no rush to hike rates again, having stated that conditions were just right for another increase, but passing on doing so.
(2) GDP. Last week’s drop in orders was reflected in weak real capital spending and inventory investment during Q2. As a result, real GDP rose just 1.2% q/q (saar), and the same on a y/y basis, falling below the 2.0% “stall speed” to the slowest pace since Q2-2013 (Fig. 4). On a happier note, as Debbie discusses below, real final sales (i.e., real GDP excluding inventory investment) rose 2.4% q/q (saar), and 1.9% y/y as consumer spending rose solidly by 4.2% q/q, and 2.7% y/y.
However, capital spending remained weak, falling 1.3% y/y (Fig. 5). But wait: A closer inspection of capital spending in real GDP shows that the following categories rose to record highs last quarter: industrial equipment, software, and research & development (Fig. 6). Transportation equipment fell but remained near its record high during Q3-2015. Information processing equipment edged down a bit from its record high the previous quarter. Spending on manufacturing, commercial, and health care structures rose to cyclical highs or remained close to the most recent such highs. The big wipe-out has been in energy-related structures. This category is down 50% y/y. (See our Capital Spending in GDP.)
The recession in the oil patch is clearly weighing on capital spending on structures and probably accounts for the weakness in some of the equipment categories. However, as Debbie and I have noted before, it is having zero impact on employment, as workers who lost their oil-related jobs quickly found employment in other industries.
Then again, another source of weakness was a significant swing from inventory accumulation during Q1 to slight liquidation during Q2 (Fig. 7). The inventory cuts were mostly in manufacturing and among wholesalers, while the pace of accumulation for both auto retailers and non-auto retailers slowed. The good news is that barring a recession, inventory accumulation is likely to resume over the rest of the year.
(3) Inflation. There’s still not much inflation to worry about anywhere. As Debbie reports below, on Friday, we learned that Q2’s Employment Cost Index (ECI) in private industries edged up to 2.4% y/y. The ECI for wages and salaries rose 2.6%, matching June’s increase in average hourly earnings (Fig. 8). No big deal: That’s still below Fed Chair Janet Yellen’s personal target of 3.0%-4.0%.
In Japan during June, notwithstanding all the stimulus provided by the BOJ, the CPI fell 0.5% y/y on a core basis (excluding fresh food) and rose just 0.4% on a core-core basis (excluding food, beverages, and energy) (Fig. 9). In the Eurozone, the headline CPI edged up 0.2% from a year ago during July, while the core rate rose 0.9%. Both the BOJ and ECB are well below their 2% inflation targets.
(4) Central banks. Above, I quoted Buffett saying that zero interest rates are like a gravitational force on asset prices. Actually, they are a gravitational force on asset yields, which are inversely related to valuations.
In any event, negative interest rates in the Eurozone and in Japan are certainly pulling US bond yields down. While both the ECB and BOJ opted to pass on additional easing at their latest policy committee meetings, they both are staying the course with their current ultra-easy QE and NIRP policies. The ECB even started to purchase corporate bonds in June, and now a 7/28 FT article has suggested that the BOE should consider doing the same. The Fed, meanwhile, is playing Hamlet on the next rate hike. Below, Melissa updates us on the latest soliloquies of all the leading actors who have proclaimed the next rate hike to be or not to be.
The Fed: FOMC Poll. It might be a challenge to keep straight which of the Fed governors and presidents are “participants” on the FOMC and which are also “members” of the policy committee and what the terms mean. The members get to vote, the others get to participate in the discussion. There are 17 participants–the five Fed governors and 12 district presidents. Ten of them are voting members. The permanent voters include all five governors and the president of the FRB-NY. The remaining 4 voting positions are rotated every year among the other 11 presidents. (For help keeping it all straight, refer to YRI’s handy Fed Center resource, which includes links to the FRB’s explanation of the FOMC’s structure, links to each FOMC participant’s speeches for the past several years, and much more. Of course, the latest FOMCminutes also includes a listing of the current FOMC members and all of the participants.)
Even harder to remember is who is a dove or a hawk. That’s because quite a few participants often change their positions in their frequent public comments and speeches. Collectively, they have certainly been dovish, since they haven’t followed up their last rate hike at the end of last year with another one so far this year. Fed Chair Janet Yellen repeatedly has promised that future rate increases would be gradual depending on the incoming data. Nevertheless, the FOMC continues to find excuses to postpone another rate hike.
But the excuses are waning: China’s currency continues to weaken without destabilizing global financial markets. The UK’s new prime minister seems to be positioning herself against a “hard” Brexit; If the UK falls into a recession, it will probably stay relatively contained. The price of oil has been stabilizing. Inflation is close to the FOMC’s 2% target. And the jobs numbers for June were much improved over May’s.
Of course, waiting until after the election to hike the federal funds rate again is a good excuse that must remain unsaid since the Fed is supposed to be above politics. Last Thursday, we showed that rate hiking has often been postponed prior to presidential elections. The latest weak batch of economic indicators, discussed above, provide additional cover for doing nothing anytime soon. In any event, let’s do a quick poll of the FOMC members by reviewing their latest prepared remarks to get a sense of where those with voting rights stand:
(1) Lonesome hawks. FRB-CLE President Loretta Mester, who has been a hawkish voting member, said in a 7/13 speech that she “supported the decision not to change rates in June.” Because of the timing and uncertainty “about the outcome of the upcoming U.K. referendum.” However, she also said that her support “did not reflect a fundamental change” to her outlook.
In her speech, Mester focused on the “risks to forestalling rate increases for too long” as doing so “increases risks to financial stability and raises the chance that we would have to move more aggressively in the future.” She added: “I believe waiting too long also jeopardizes our future ability to use the nontraditional monetary policy tools that the Fed developed to deal with the effects of the global financial crisis and deep recession.”
Everyone knows exactly where FRB-KC President Esther George, another voting member, stands. She has been the lone dissenter calling for another rate hike during three out of the five meetings so far this year. She supported the January decision, then dissented in March and April. After supporting the June decision, she again dissented in July.
(2) Uber-dove. FRB-SL President and FOMC voting member James Bullard changes his stance more often than any of his colleagues. He recently has turned super-dovish. In a prepared presentation on 7/12, he said that the FOMC’s old “narrative” may have outlived its usefulness and should be replaced with a new one. In his view, the old narrative is one in which the macro economy is expected to steadily rise and converge with historical long-run averages, and accordingly policy rates should rise. Bullard’s new narrative is essentially that there are too many unknowns to forecast the future, so the policy rate should follow the existing state of affairs. Bullard’s simple forecast would prescribe a relatively flat 63bps policy rate over the next two and a half years.
(3) Bird watching. Another voting member recently expressed concern about Brexit fallout–Fed Governor Jerome Powell in a 6/28 speech. It’s possible that he could change his mind now that the risk associated with fallout has diminished, but he is on the fence.
(4) Quiet birds. Four other voting members have been relatively silent in recent weeks on monetary policy. Governors Daniel Tarullo and Lael Brainard’s most recent speeches (linked here and here, respectively) had dovish undertones. FRB-Boston President Eric Rosengren hasn’t given a prepared speech since June 6, but seemed somewhat hawkish at that time. FRB-NY William Dudley hasn’t spoken publicly since mid-May.
Federal Reserve Vice Chairman Stanley Fischer hasn’t given any prepared speeches since June 22. In a 7/1 CNBC interview covered by the WSJ, he sounded cautiously upbeat. Don’t forget that earlier in the year he said that four rate hikes would be in the ballpark this year, and that’s obviously not going to happen.
(5) Big bird. Actually, it is surprising how little chatter is coming out of the normally chatty Federal Open Mouth Committee. Maybe many participants are on vacation. Or maybe they realize that they have been confused and are having mercy on us by not sharing their confusion. In any event, the views of Fed Chair Yellen matter more than most of the others, and she undoubtedly will share them with all of us on August 26, when she is scheduled to speak at the annual Jackson Hole meeting. We expect she’ll maintain her cautious approach towards normalizing monetary policy.
Movie: “Jason Bourne” (-) (link) is the fifth in a series of movies based on the Robert Ludlum spy novels. Matt Damon stars as Bourne, who is out in the cold from the CIA, where the chief has covertly funded a Silicon Valley social media company to spy on all of us. Each of the Bourne movies seems to have an improbable car chase scene longer than the previous one through the gridlocked downtown streets of a major city. The swat truck chasing Bourne in Las Vegas in this film destroyed 170 cars. The seconds-per-scene editing is fast-paced and almost nauseating. Take motion sickness pills before seeing this movie. Damon was better as a Martian than as a spy.