One way to think about US equity valuation and price volatility is to break up the fundamental drivers of each into 2 distinct components:
1. Current/future dividends and the uncertainty around these payments based on earnings and corporate payout ratios.
2. The future value of the business itself, based on sustainable return on capital and reinvestment rates. This is essentially its ability to generate long run cash flow in excess of dividends.
The CME Group recently published a very clever analysis along these lines using its S&P Dividend Index Futures product to differentiate how markets assess future index payouts (#1) from the residual value of the companies (#2) in the 500. Three points from their note:
#1: Over the course of 2020 investors have gone from very confident in rising S&P dividend payments (February) to very concerned that payouts would be slashed (April) to hopeful that companies would only modestly trim their dividends (now). The following chart shows the levels of annual S&P 500 dividend payments that were discounted in futures prices during those months.
#2: The sharp-eyed reader will note that the July expectations (green line) are not anywhere near to February’s levels (blue line) but the S&P 500 is quite close to where it was early this year. That is because US stock prices are now untethered from the Futures price-derived forecasts of future dividend payments. This chart from the CME note compares the S&P 500 to the present value of 10 years of future expected dividends (as measured by annual Dividend Futures Index prices).
The difference is striking. The S&P closely tracked expected future dividend payments from 2016 – 2019, but now the index seems dramatically overvalued (light blue line way above dark blue line) versus future payouts.
#3: The CME staffers conclude that the S&P 500 now has significantly more duration risk because of this dividend/principle valuation disparity than in prior years. Like bonds with low yields (or, in the extreme case, a zero-coupon bond), stock prices are now more reliant on investor perceptions of distant cash flows rather than the next few years of dividend payments.
Our 2 cents on this: Big Tech’s increasing dominance of the S&P 500 is another explanation for this noticeable valuation gap between the net present value of expected future dividends and where the S&P 500 actually trades. Traditional dividend payers – Energy and Financials, for example – are being crowded out of the index as Tech scoops up ever more market cap. Amazon (5% of the S&P 500) pays no dividend. Nor does Google (3.5% of the index) nor does Facebook (2%). Right there is 10% of the S&P whose valuations are at record levels, and just wait until Tesla – another non-dividend payer – gets added…
Will this make the S&P 500 more volatile, as the CME researchers propose? We’re not so sure. Volatility is a function of market perceptions of future cash flows AND the sustainability of corporate returns on capital. Investors may be willing to give Amazon or Google more benefit of the doubt on these points than JP Morgan or ExxonMobil. This has certainly been the story of 2020 thus far. While we do agree that volatility will remain elevated, we’re chalking that up to more prosaic issues like the pace and magnitude of the US/global economic restart from COVID lockdowns and not valuation per se. As we often note in these pages, valuation – even the CME’s very useful dividend-based model – is just math. And math is not an edge on its own.
CME Note (highly recommended): https://www.cmegroup.com/education/featured-reports/dividends-changing-expectations.html