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December 01, 2008

Yield Up Ahead?

Yield Up Ahead?...Up ahead? Are you kidding us? At least in terms of current numbers, we're seeing individual equity yields we have not seen in decades right now. On face value, these yields are nothing short of mouthwatering. But, as always, and especially in the current environment, we need to think through visceral reactions to immediate perceptions. Time to talk about yield for a few minutes. First, as we have been highlighting in our early year themes and considerations discussions for a number of years now, we continue to believe yield will be an important macro equity market theme ahead based simply on demographics. Maybe more so now given events of the current year. We remain convinced the baby boom generation as a whole simply has not saved for retirement in any meaningful fashion, relying quite heavily on residential real estate values and equity market "savings", as opposed to wage based savings, for net worth acceleration. As a very rough estimate, we have to believe close to $8+ trillion in perceived household wealth has been lost over the last few years. The illusion of "saving" that has been real estate and equity price inflation has been shattered. But in no way does that mitigate the forward reality income need as the boomers walk every more swiftly into theoretical retirement years. Amid the terror, panic, paranoia and hysteria of the moment in the financial markets, the need for yield has, if anything, grown ever more pressing for the boomer crowd. This "theme", if you will, is not about to abate any time soon. So, it's just a wonderful thing that so many stocks now sport quite the attractive dividend yields, right?

Secondly, from a macro equity valuation perspective, it's time for a quick check in on historical equity market dividend yield context as a bit of a valuation marker in and of itself. With the large equity sell off this year, where are we set against historical precedent? Have a look.

In the chart above we're using Bob Schiller historical data back to the turn of the last century. As you can see, we've marked the average S&P dividend yield since both 1900 and 1950. As of now, we're essentially looking at an S&P yield that has hit the average experienced over the last six decades. Why divide the world into 1950 to date and 1990 to date periods? As you can see in the chart, the first half of the last century saw equity dividend yields spend the bulk of their time above 4%. There was clearly a different mind set toward what investors expected from equities, and dividends were a big component of that prior era mindset. That changed with the big equity bull market period of the 1950's, and perhaps peaked in generational fashion (now clear in hindsight) with aggregate equity market yields approaching 1% at the dawn of the current century. Although investors today have little to no experience with this concept, there were many periods in the pre-1950's world where aggregate equity yields consistently exceeded like company corporate bond yields. Equities were indeed thought riskier than bonds, being ranked well below senior debt in terms of the corporate capital structure as this applies to potential liquidation. Implicitly, investors demanded a meaningful risk premium in equities in the form of dividends to be subordinated to senior debt claims on a company's assets. Wow, what a novel idea, right?

Again, we saw the beginning of the secular change in thinking regarding equity risk as yields "demanded" by investors dropped meaningfully in the 1950's to the present, interrupted only by the 1970's bear market interlude. But as we look back across time, we need to remember that from 1950 to present, we have generally ridden a macro bull market equity wave of price appreciation point to point. The 1966-1982 period was indeed one big sideways correction for equities, and it's during that period where yields trended higher. Otherwise equities in general have enjoyed an upward nominal dollar price trend as a very general comment. Investors "learned" over the last half-century to rely more on price appreciation from equities than dividend yield in attaining satisfactory total return. Punctuated, of course, by the stock buyback phenomenon of the last decade and one half.

But as we look ahead, we need to at least be open to potential perceptual change. Let's face it, as of the Thursday prior to the Thanksgiving week, the S&P on a price only basis was down 49.1% YTD. In essence, the S&P had lost half its total recorded history value in a little over one year. Enough to spark change in forward investor "demands" from equities? Enough to refocus investor attention from primarily price only return to a combination of yield and price return? Meaningful change that is more secular than not takes time, so we have no current certainty in terms of answering that question regarding the character of forward investor attitudes toward yield, and how that potential change would be discounted in equity prices. We just thought it important to step back and have a multi-generational look at the shifting character of the equity market and investor perceptions. Personally, in the current period we need to remind ourselves at all points in time to remain open to almost any outcome. The only thing we really know at the moment is that no one knows what lies ahead in this special environment. Comforting, right?

An observation from the chart above that we do believe has implications for the current market is the history of nominal dollar S&P dividends. As you look back over the period of the 1910's through 1940's, there were a number of periods where equity market dividend yield spiked very significantly. We all know that was a result of a decline in equity prices as opposed to a massive increase in company dividends. But the important issue is that post these clear and significant spikes, aggregate equity yields dropped like a rock. Was the subsequent drop in S&P dividend yield a result of massive equity market rallies? Far from it. It resulted from huge drops in nominal dollar S&P dividends themselves. Companies either went bankrupt or cut dividends very meaningfully. What we've done in the following graph is to chart nominal dollar S&P dividends over the 1900-1950 period, and the 1950 to present period. Two different time frames representing two different "eras" in investor thinking and equity price discounting regarding dividends and yield, as we explained above. In the top clip you can see the cyclical contractions in actual nominal dollar corporate dividends that occurred with some regularity during the first half of the last century. No wonder investors demanded meaningful dividend yields as they priced equities during that period. Not only were actual equity prices volatile, so too was the stream of actual cash received by investors in the form of dividends.

Conversely, as we look at the bottom clip of the chart above, volatility in nominal dollar corporate dividends has virtually been absent over the last half century. We saw a temporary decline in actual cash dividends in the latter part of the last decade, but it was a blip on the proverbial screen compared to prior early 20th century experience of 30-50% declines.

So, why have we dragged you through this and how is this important to our current circumstances? Sorry to beat the proverbial dead horse one more time, but we believe we again need to put prior half century equity market dividend experience in context set against the prior half century credit cycle dynamics in the US. In a recent discussion on our site we reviewed the very strong historical directional correlation between nominal dollar US corporate profits and US credit market debt relative to GDP. Point being that we are convinced credit cycle dynamics of the last three to four decades strongly influenced and supported corporate earnings growth in a big way. A chart of exactly what we are talking about follows.

If indeed our supposition regarding the linkage between the credit cycle and nominal dollar corporate earnings acceleration is correct, then by extension can we suggest that US credit cycle dynamics also positively influenced the ability of corporations to support dividend payments over the prior three-plus decades? We think that's more than a fair statement. As you'd guess, the following chart chronicles both S&P nominal dollar dividends set against the same credit market debt relative to GDP character since 1950. Directionally correlated, as is the trend in corporate profits? You bet.

Can we now suggest that we need to at least be open to the idea that change in US credit cycle dynamics ahead may indeed portend change in the character of US corporate dividends to come? And as the credit cycle continues to reconcile, could we possibly be looking at a future decline in aggregate S&P dividends paid? Again, we think this is a fair line of reasoning and deserves both consideration and monitoring in forward decision-making. As we look back over the last year or so, the poster child for dividend change so far has been the financial sector. Either massive cuts or outright dividend elimination has been the hallmark of the sector, along with imploding earnings and stock prices. All as a result of meaningful change in macro credit cycle dynamics? Sure seems that way. In late summer we watched BofA CEO Ken Lewis proclaim on the tape that he saw no reason for a dividend cut. About six weeks later, BAC cut their dividend in half. We need to be open to any outcome in the current environment. It's as simple as that.

Last item of importance. We have been suggesting in our recent discussions that we need to be very aware of the transmission of financial sector price declines (both bonds and stocks) and continuing credit market contraction into the real economy as we move ahead. It's already playing out in terms of contracting consumption and employment. We believe this accelerates in 2009. As this relates to the topics of equity dividends, it may have been the financial sector cutting dividends that was the highlight of 2008, but what is to come in 2009? As the real economy is hit with the full brunt of credit market and household balance sheet contraction fallout in 2009, will we see dividend cuts broaden well beyond the financial sector as a result of meaningful earnings disappointments? And if so, what will be the magnitude of the dividend cuts to come? Although we have no absolute certainty, we believe the case for this phenomenon is building. We'll look at some real world numbers in the table below that "tell us" to be very aware of this potential. Have a look. Admittedly this is an incredibly small sample, but it's the concept we're after here. Also, the following numbers are as of month-end, benefited by a very meaningful prior one week rise in price.

In terms of "real economy", GE and Dow pretty much fit the bill, no? In their wildest dreams, we have to believe that most investors of the moment never would have imagined an 8+% GE dividend yield. But here we are. On face value, anywhere near 8+% dividend yields are quite the tempting proposition...until we get to the last column in the table above that is the payout ratio. At the moment, current analyst estimates for the S&P in 2009 center around $90, a 30+% increase over 2008. We believe this is a wildly unrealistic number for 2009, but that's our personal opinion. Also, we have been harping on the linkage between credit cycle dynamics and both corporate earnings and dividends. So as we look at very high dividend payout ratios for companies such as GE and Dow, we have to ask ourselves as credit cycle and financial sector price deterioration dynamics "transmit" into the real economy next year, will these companies really be able to achieve earnings estimates currently on the table by the analyst community? For if not, by default the payout ratios we see above will increase. At what point, or payout ratio level, does a GE or a Dow need to make a hard decision about cash dividend payments? Especially if we remember that these folks need a certain amount of at least maintenance cap-x. Although we have absolutely no idea what will happen ahead, can you imagine perceptual market reaction and fallout if a supposed blue chip like GE cut their dividend? You get the point.

So in summation, a rising S&P dividend yield is telling us something about equity valuations. As we noted, we now rest at a yield level that is the average for the last 60 years, a level we have not seen in close to two decades. We have discussed the case for the "stocks are cheap" argument based on estimated earnings on our site recently. It's the earnings assumption that's the problem. In like manner, it appears that stocks are reasonably priced based on the dividend yield experience of the last six decades. But is the assumption of a static or growing cash dividend stream for the S&P in aggregate also a problematic assumption? Could we be embarking on a wider sector display of dividend cuts in 2009? We believe it's a very real possibility. So, we need to incorporate this into our thinking about macro valuations and company specific investment possibilities. We need to look well beyond perceptual dividend yields of the moment in terms of individual investments. The siren song of very high single digit or low double-digit yields may turn into an air raid siren of danger before 2009 has ended. Do not blindly accept dividend yields of the moment as being sacrosanct. What has transpired so far in 2008 has already taught us that nothing is sacrosanct. Nothing. We continue to believe the macro investment theme of yield is and will be important ahead. We're just walking in a more dangerous minefield near term. When it comes to yield oriented equities, just remember that quite simply, if a yield appears too good to be true, it probably is.

Market Observations
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Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

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