Broker Check

The State of Equities and the Power of Dividends

| February 28, 2022

For some, the Olympics mean war, and I don’t mean in the sense of athletic competition. It’s been noted in academic circles how Russia has a history of invasions during the Olympic Games. The private sector is paying attention too:

Well, lo and behold, the Olympics are done, and Russia invaded Ukraine. Unsurprisingly, some in the international community are fearful, upset, and afraid.

From an investing perspective, we saw this fear come to life in MAPsignals’ trusty Big Money Index (BMI), which measures institutional investor activity. The BMI dropped to 39.9%, its lowest mark so far this year, as a result of selling that began a week ago:

From an investing perspective, we saw this fear come to life in MAPsignals’ trusty Big Money Index (BMI), which measures institutional investor activity. The BMI dropped to 39.9%, its lowest mark so far this year, as a result of selling that began a week ago:

We think now is a good time to recheck our macroeconomic forecast for 2022 and belief in not trying to time the market, especially when it comes to geopolitical risk. As readers of this blog know, late last year we unveiled our stock market forecast for 2022 where we projected the S&P 500 would rise to about 5,250 and the Dow Jones Industrial Average to around 40,000.

Since then, equities have dropped, especially since the now-realized fears of Russia invading Ukraine and the recognition that inflation is a persistent problem. So, it's prudent for us to revisit this discussion because, to reach our year-end equity targets, it will take a 20.7% increase in the S&P 500 and a 17.4% jump in the Dow (as of two Fridays ago).

Even though there’s been an international invasion that could escalate further, realistically, it's unlikely to change the long-term outlook for corporate profits, which look good as of early February:

As a result, this could end up being a buying opportunity.

Additionally, for the time being, there's an argument to be made that inflation is likely to be equities’ friend, not foe. Companies with pricing power, commodity companies, and materials firms should do well in this environment.

In other words, dividend growth companies should shine, but we'll get to that later.

Turning to some analysis, the message from our capitalized profits model hasn't changed, at least not yet. Remember, our model takes the government measure of profits from gross domestic product reports and discounts them by the 10-year Treasury note to calculate fair value.

Since earnings for the fourth quarter of last year are not completed yet, we still look at the corporate profits for the third quarter of 2021, which were up 19.7% versus a year ago and up 21.2% versus the pre-pandemic peak. Remember, these are record-high levels.

As always, the real question is what discount rate should be used, especially in today's environment. If we use an approximately current 1.9% 10-year Treasury yield, the model suggests the S&P 500 is grossly undervalued. But with the Federal Reserve about to embark on a series of rate hikes and inflation likely to keep running hot, the 10-year yield will probably continue its rocky upward trend.

So, to be cautious, we plug in alternative, higher long-term rates to determine equities’ fair value. Again using third quarter profits, our model shows it would take a 10-year yield of about 3% for the stock market to be trading at fair value. Importantly, that assumes no further growth in profits, which seems unlikely (see the table above).

With a more realistic 10-year yield of 2.5%, all it would take is profits 3% above the third quarter level for our model to estimate a fair value for the S&P 500 at 5,250, which is our projection for the index at the end of this year.

But it’s clear the winds of change are blowing hard in 2022. It seems the pandemic is winding down, our sovereign borders are in flux, and monetary policy is ripe for an overdue overhaul. But none of that is new, if you look out over time:

If you look closely at that chart, there are surely “big events” on there that require a mental nudge to be remembered (if they’re memorable at all). So, even with seemingly big landscape changes afoot, we think equities are likely to rebound and work their way higher. While the bull market in stocks won't last forever, the data doesn't show it to be over yet.

Nobody can tell how the market will perform with certainty. That’s why consistency as an investor is so important. Missing the best days can cause irreparable damage to the long-term growth of a portfolio:

Also, intra-year declines are normal. Going back to 1980, there were negative dips every year, even in the best years:

This is how markets work.

More Praise for Dividends

Cornerstone has pounded the table on dividends and dividend growth stocks for more than a year for several reasons. Well, it looks like 2022 is shaping up to be the year of the dividend. And at CFS, we love it. Our philosophy is that growing dividends from high quality companies can make a significant positive impact on a portfolio.

To put this into context, let’s illustrate why dividends play a surprisingly important role in long-term equity performance. Albert Einstein summed it up well when he called compound interest the “eighth wonder of the world.”

Just look at the chart below. Clearly reinvested dividends are a driver of huge growth, much more than just market returns alone.

Here’s the same information in bar chart form (notice how the biggest gains come later):

One reason this type of exponential growth power doesn't get enough attention is because it requires discipline and patience. Also, this approach isn’t nearly as flashy as meme stocks or finding the next, so it doesn’t garner media attention. But you can see in that chart that reinvesting dividends has obviously been a winning choice.

Now let’s look at the current setup. Here are five reasons why a dividend growth strategy is ideal for today’s market conditions.

Ease Volatility

Dividends provide a stabilizing force for portfolios when volatility is highest. Markets have chopped along for a while now. Dividends can smooth the ride. For example, a 3% yield matters a lot more when you're up 6% for the year than when you're up 20%.

Manage Uncertainty

Today, investors must juggle several big issues, including rising interest rates, elevated inflation, geopolitical pressures, and more. This is when investors seek stability, and it can be found in dividend-paying, blue-chip stocks with strong balance sheets. They waver less than speculative companies.

Buybacks, Dividend Raises

Years of strong economic growth filled corporate coffers, which has in turn created record levels of capital being returned to shareholders via dividends. For example, last year S&P 500 companies paid $541 billion in dividends, which is up 176% from $196 billion in 2009:

Inflation Hedge

Investors are scrambling for income to combat the rising cost of pretty much everything. Remember, even with ballooning interest rates, the 10-year Treasury yields about 2% right now. When factoring in 7% inflation, that asset locks in an annual 5% loss.

Multiple Growth Opportunities

People are turning to stocks to plug the income gap. However, index-level yields are low (the S&P 500 yield is about 1.5%). So, investors look to certain individual equities – the ones that reward shareholders through both asset appreciation (i.e., price rising) and growing dividend payments. These are dividend growth stocks and they’re fueled by profits. More specifically, we at CFS seek a portfolio of stocks with strong cash flows that yield an average between 3%-4% or more and consistently grow dividends 5-10% every year. These are the types of companies we target in our models.

Final Thoughts on Dividends

In this environment, we focus on stocks with competitive yields that can also grow their payouts over time and support dividend payout ratios with strong profits. But it’s critical that investors not reach for yield.

What does that mean?

Huge dividend yields are enticing. And while a strong yield is important, a sky-high payout is almost assuredly a red flag. Firms with these “jumbo yields” often bump up the dividend to compensate for poor fundamentals and share performance. In these cases, dividend cuts usually follow.

Let’s again go back to what’s required for a successful dividend growth investment approach – discipline and patience. These qualities are not exciting, nor are they in ample supply for most investors. But if we look at the history of dividend growth stocks, they’ve outperformed high yield stocks, non-dividend payers, and dividend payers significantly (left chart), with less volatility (right chart):

Quality matters. And the disciplined, patient investor wins.

Securities sold through CoreCap Investments, LLC.  Advisory services offered by CoreCap Advisors, LLC.  Cornerstone Financial and CoreCap are separate and unaffiliated entities.