“When I started in this business back in the ’80s, you bought bonds for the coupons and stocks for the capital gains. That’s been flipped around.” – David Rosenberg
Conventional investing wisdom says that you should invest in stocks when you’re young, have a long time horizon and can deal with the increased volatility that comes with higher growth expectations. Then, as you age, you should slowly shift into a more “fixed income” dominant allocation strategy in order to reduce the wild swings and to generate the income needed to sustain spending in retirement. But what do you do when that income is nowhere to be found? Several weeks ago in our post NIRP Is The New ZIRP we profiled the recent emergence of negative interest rates onto the global financial scene. This week we take a look at one of the intended consequences of these loose interest rates policies – an increased appetite for risky assets amongst income-starved investors.
Factset’s latest edition of Dividend Quarterly offers up a number of interesting charts and insights dissecting the fundamentals underlying the dividends being paid out by S&P 500 companies. The first thing to note is that the US stock market now offers a higher quarterly coupon than the US bond market. As the image below shows, the 10-year US Treasury yields only 1.5% vs a dividend yield of over 2.0% on the S&P 500. While this is not the first time stocks have yielded more than bonds in the post-financial crisis era, it would be considered highly abnormal when viewed over a longer term context.
Peeling back the layers on the S&P 500’s dividend yield, we see that companies are having to allocate more and more of their earnings in order to sustain the current payouts. The blue line in the chart below shows a payout ratio that has steadily been climbing over the past five years and now sits at roughly 40%. This means that for every $1.00 of S&P 500 earnings, nearly $0.40 of it is being paid out to investors in the form of a dividend.
This level has only been eclipsed twice since the late 90’s. Both times were relatively short-lived and were driven by a collapse in the denominator (earnings) amidst steep recessions. In contrast to the current trend, during the economic expansion of 2003-2007 the payout ratio steadily fell to below 30% as earnings grew at a faster pace than dividends.
So what is driving the current trend of a steadily increasing payout ratio? One partial explanation is simply that earnings have not grown very rapidly in this economic expansion, and in fact have actually been declining over the past several quarters. Another explanation is that companies see a lack of compelling reinvestment opportunities, and/or are holding off on new investment until they see less political and regulatory uncertainty. Rather than simply stockpiling cash, companies have decided to return capital to their stockholders in the form of dividends.
A final explanation for the elevated payout ratio is that corporate CFOs recognize and are playing into the market’s insatiable appetite for yield. Stocks with stable and rising dividends have been the bells of the ball, so a more aggressive dividend policy would be a logical strategy for a CFO looking to boost a company’s stock price. By the same token, dividend cuts are highly undesirable and companies have proven they will do almost anything to avoid them. The chart below illustrates this; it shows the number of S&P 500 companies that are actually paying out more than what they earn in order to uphold their current dividend levels. Much of the recent increase is attributable to energy companies that continue to pay out the same level of dividends despite having a hard time turning a profit amidst low oil prices.
Economist Peter Clarke was recently quoted by the WSJ as saying that there is a worldwide “shortage of assets with stable, secure running yield.” Given this reality, for many yield-hungry investors Stocks Are The New Bonds. This consequence of low interest rates is not at all unintended; rather it is and always has been the goal! Bernanke’s original aim with low interest rates was to push risk-averse investors further out on the risk curve, resulting in higher stock prices and a subsequent wealth effect he referred to as “a virtuous circle”. So far his plan seems to be working as he originally envisioned it.
In closing, we want to be clear about our thoughts on all this. Stocks are NOT the new bonds! No, stocks are still stocks, and they always will be. The dividend yields on broad market indexes can be erased in a single afternoon of price action, and the small incremental yield above and beyond what bonds offer does not come anywhere close to compensating an investor for the additional risk. Therefore, we in no way endorse the idea that high yielding stocks serve as an appropriate substitute for bonds. Aside from stocks, there are some opportunities out there to capture attractive risk-adjusted yields in excess of what publicly traded bonds are currently offering. Marketplace lending (peer-to-peer and peer-to-business) and hard money lending, for example, are two areas that we are actively participating. The overall reality, however, is that we are simply in a low yield environment. There’s no silver bullet, so we all need to keep our heads on straight and simply adjust expectations to match the reality of the current environment.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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