Thoughts on U.S. Market Valuations

Dividend Payout Ratio

At the Chartered Financial Analyst (CFA) Institute Annual Conference in Philadelphia last month, there were a number of conversations with dour outlooks for the future of U.S. equity markets. The center stage of the conference featured a debate between Yale Professor Robert Shiller, designer of the CAPE (cyclically adjust price-to-earnings) ratio, versus my mentor, Professor Jeremy Siegel.

Shiller has a more subdued outlook for future returns than Siegel, who is a bit more optimistic. Jack Bogle also presented at the conference and suggested we’ve seen strong gains in the markets over the last 35 years that resulted from valuation expansion, and hence also had a more subdued outlook. Bogle’s model was fairly simple: take the 2% dividend yield on the market today, add in his personal estimates of 4% earnings growth, and subtract 2% from speculative market activity or his anticipation of a decline in valuation ratios over the coming decade, and you come up with an outlook for 4% returns over the coming decade. If we assume there is 2% inflation, this would lead to just a 2% real return after inflation. Note that this is largely similar to Shiller’s outlook for returns.

One chart that I think is not talked about enough in the context of valuation changes on the market is the dividend payout ratio of the market. I show a smoothed 10-year average dividend payout ratio in the spirit of Shiller’s 10-year smoothed earnings for the CAPE ratio. Prior to 2000, the dividend payout ratio averaged 60%. Since 2000, the dividend payout ratio has averaged 40%. This change in the nature of how firms reinvest their earnings, conduct stock buybacks, and pay dividends is absolutely critical to the future earnings growth we are likely to get.

CAPE EPS Growth Rate

Those who assume that earnings growth rates will revert to some historical average growth rate when firms paid out 60% of their earnings as dividends are assuming that all this money not being paid out—used for either buybacks or other reinvestment in business—is being completely wasted. That is an incorrect assumption, in my view.

This chart looks at the rolling 10-year and 20-year earnings growth rates of the CAPE earnings per share (EPS) that Bob Shiller uses to make his dour forecasts on the market. If these numbers were to “mean revert,” that would be a cautionary tale for the markets. But in my view, the earlier declining dividend payout ratio means we are likely to see upside changes to these earnings figures. What is possible?

Changing dividend payout ratios have already translated to better earnings growth. Prior to 1982, the average dividend yield on the U.S. equity market was approximately 5% per Shiller’s data, and we had an average dividend payout rate of nearly two-thirds of earnings paid out as dividends. With only a third of earnings reinvested, firms were still able to achieve earnings growth of 3.3% per year.

Shiller Data

Since 1982, payout ratios declined to an average of 51.1%, while at the same time firms started conducting stock buybacks. The average EPS growth during this period of reducing dividend payout ratios was an increase of 160 basis points (bps) per year, from the previous long-term average of 3.3% per year to 4.9% per year.

When we look at the last 20 years, and particularly the last seven, we see consistent signs of 2% dividend yields with 2% net buyback ratios. These net buybacks are going to continue to support earnings growth for the 10-year look-ahead period. These firms have locked in future EPS growth because they reduced their shares outstanding.

Returning to the table above, where I showed the earnings growth since 1982 as being higher than the previous 110 years, the current dividend payout ratios are consistent with an even further drop in the payout ratios from their average since 1982. I can see a case that earnings growth picks up even from that 4.9%-per-year mark that we had for the period 1982–2016. It would not surprise me to see earnings growth of 6% to 7% per year over the next decade.

Dividends Buybacks

The standard pushback is that firms are just leveraging up to conduct buybacks—that interest rates are at historical lows, leading to higher margins than are sustainable. The reverse case is that the changing composition of companies—into higher-margin businesses that have more revenue abroad with lower tax rates than in the U.S.—also means margins may not be mean reverting anytime soon either. Of course, no one knows how the future will unfold, including me.

The charts above caution anyone relying on historical patterns of earnings growth trends from overextrapolating them into the future. Professor Siegel looks at the current earnings yield of the market associated with a 20 price/earnings ratio and thinks 5% is a pretty good indicator of long-term, after-inflation real returns. Add in inflation of 2% and you get 7% nominal returns. This is a touch below their historical 6.5% to 7% that he showed in Stocks for the Long Run as being the historical return to U.S. equities, but it is not dramatically different. I think his model for looking at the markets makes more sense than some of these more dour predictions—for what that’s worth.

Jeremy Schwartz is the Director of Research at WisdomTree Investments.

Important Risks Related to this Article

Dividends are not guaranteed, and a company currently paying dividends may cease paying dividends at any time.

Planning to Leave a Family Legacy? Why Writing a Will Is Not Enough

Family 2

About 20 years ago, when you first drew up a will, you decided to leave the lake cabin to your daughter, and your sailboat to your son—both to be passed on to them upon your death. And you haven’t touched the will since.

But what if you’ve remarried, and now have two step-children? What if the sailboat is long gone, and now you feel passionate about leaving an endowment to the nonprofit where you volunteer?

In the coming years, an estimated $3.2 trillion in assets is expected to transfer from one generation to the next in the United States. Our Wealth Transfer Report, produced with research partner Scorpio, highlights the importance of preparing for the coming shift in generational wealth. It’s increasingly important for families to ensure that the plans they’ve laid out for the transfer of their estate keep pace with their ever-changing lives.

Of the 1,235 Americans surveyed, slightly more than half, or 54 percent, have a will in place, but only 30 percent have a full wealth transfer plan. There’s no question that a will is a good place to start. But in many cases, it may not be enough to adequately distribute family assets, preserve family wealth, and create a long-term legacy that reflects the family’s values and wishes for future generations.

Our research underscores the importance of having a comprehensive wealth transfer strategy. The way that wealth is passed on can greatly affect how long a family legacy will last and how meaningful it might be.

More than a simple will

A will is often sufficient for an individual with a small estate and no extenuating circumstances, says Catherine Walker, a senior trust consultant for RBC Wealth Management-U.S.

A will is a matter of public record, meaning anyone can access it, and it can be contested in court.

But there are limitations to a will. For instance, “a will can’t preserve wealth for multiple generations, or determine how and when distributions occur,” says Walker.

Another limitation is that a will can be easily forgotten. Typically, the document is stored away and doesn’t get revisited or revised as life evolves, says Malia Haskins, a wealth strategist for RBC Wealth Management-U.S.

That’s one of many reasons why RBC Wealth Management strategists advise people with large estates, large families, blended families or special situations to create a comprehensive wealth transfer plan. It should encompass all facets of an estate — everything from real estate and securities holdings to business and philanthropic interests.

A comprehensive wealth transfer plan should, at the very least, include four key documents: an up-to-date will, a revocable trust, a power of attorney, and a health care directive. As the American population ages, issues around health and long-term care should be addressed in estate planning conversations.

“A lot can happen between now and death,” cautions Haskins. “Planning is even more important if parents are concerned about heirs’ ability to effectively manage inheriting wealth, whether due to family responsibilities, or impediments such as health issues or addictions,” she says.

“If your heirs are young children and you don’t know what the future holds, you can create a trust to protect the assets until they reach a certain age,” says Haskins. Trusts give parents an added level of control by allowing them to stipulate when and how the children receive their assets, and even what conditions might disqualify them from inheriting.

Parents who transfer assets to a revocable trust avoid probate and retain full control. They are able to make changes to the trust which, upon their death, converts to an irrevocable trust that cannot be altered. Assets put directly into an irrevocable trust are no longer part of the estate and aren’t subject to estate tax.

Walker helps clarify the distinction between a will and a full wealth transfer plan. “A will says who gets what, but a trust says who gets what, when, where and how,” says Walker. A will, which is a public document, can be embedded within a trust, which is private, rendering the contents of the will private as well.

Methods of wealth transfer

People with comprehensive wealth transfer plans commonly use multiple methods and structures to pass on their wealth. Legacy planning and philanthropic techniques – such as estate freeze trusts, generation skipping trusts and charitable giving vehicles – can reduce the size of a benefactor’s taxable estate, minimize taxes, and protect assets left to the next generation.

Parents can also establish trusts for specific purposes, such as provisioning for the needs of a disabled child, or a keeping the proceeds from a life insurance policy out of an estate, in order to give beneficiaries the liquidity to help pay estate taxes.

If parents are interested in preserving their wealth for multiple generations, they can set up a dynasty trust. Assets in the trust will be distributed to children for life, with remaining assets going to grandchildren or later generations. The transfer of generation skipping property can be subject to an additional tax. Some states also limit the duration of the trust.

A limited liability company (LLC) is a good option for property and investments that are difficult to divide among multiple beneficiaries, says Haskins. Assets can be put into an LLC, in which the benefactors and beneficiaries become shareholders.

Another option is a life estate, which is employed in second marriages where the husband wants his new wife to continue living in their home after his death, but the house will pass to his children when she dies, says Ringham. A qualified personal residence trust is similar, but the right of use is limited to a certain number of years.

If people are passionate about a cause, they can create a long-term philanthropic strategy using different types of trusts, a private foundation, or a simpler donor advised fund. A foundation is a good choice for benefactors who want to donate a large gift, exert greater control, or ensure long-term family involvement.

Preparedness breeds confidence

Given the pace of change in many people’s lives, wealth transfer plans can quickly become outdated. Parents should review and revise their wealth transfer strategy at least once a year as circumstances change. For instance, a business succession plan, or long-term care arrangements for a child with special needs are two types of plans that people should revisit annually, says Bill Ringham, vice president and senior wealth strategist at RBC Wealth Management-U.S.

Think of a plan as a guide for your heirs, says Ringham. For many people, receiving an inheritance is their introduction to wealth. For that reason, a good estate plan should anticipate the questions that a first-time inheritor might have about fulfilling their benefactor’s wishes and carrying out their responsibility. It’s likely that inheritors will want to know, “Do I need to pay taxes on these assets?” or “Does my benefactor have a financial advisor who can help determine how to manage the inherited assets?”

Indeed, our report found a strong correlation between a person’s degree of preparedness and the confidence they have in their heirs’ ability to maintain their legacy. Across the U.S., UK and Canada, more than half of parents surveyed who have a wealth transfer strategy are confident in their heirs, compared to a third who’ve done no preparation.

Being unprepared to give or receive wealth can put tremendous strain on family relationships. And differing expectations can lead to disagreements over the distribution of assets or how to manage the benefactor’s estate.

“Inheritance can be a major responsibility,” says Haskins. “That’s why it’s appealing for people to have peace of mind from knowing their beneficiaries are in a better position to be stewards of the family wealth.”

RBC Wealth Management, a division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC.

The Surprising Way the Bond Market Matters for Stocks

Neat rows of colored beads on an abacus with a single blue bead to the side

One of the reasons stocks have done as well as they have in 2017 is that earnings growth has rebounded. Unlike recent years, when stocks were driven largely or exclusively by multiple expansion—i.e. investors willing to pay more per dollar of earnings—this year’s gains have come from companies actually producing stronger earnings. This is supportive of the market.

What is less supportive is the cumulative effect of years of multiple expansion, a trend that has left U.S. equities expensive by most metrics. Whether or not stocks can continue to sustain current valuation is partly dependent on what happens in the bond market, but just not in the way many people think.

When comparing stocks to bonds, investors typically focus on the relationship between interest rates and equity multiples. This is both empirically evident and based on basic finance, i.e. a lower discount rate supports higher valuations. Unfortunately, this relationship has been less relevant in the post-crisis environment of already low rates. Instead, investors need to focus on two more nuanced measures: the term premium and bond market volatility.

Low or negative term premium

The term premium measures the marginal return to investing in a long-dated bond versus constantly rolling a series of shorter maturity instruments. While normally positive, it has been unusually low or negative in recent years.

Term Premium Equity Valuations

This is important. Since 2010 the term premium has explained roughly 40% of the variation in the S&P 500 earnings multiple (see the chart below). Price-earnings (P/E) ratios have averaged 18.5 in months when the term premium was below 0.5, roughly the post-crisis average; in all other periods multiples were below 15.

MOVE hasn’t moved

The other key measure to watch is bond market volatility. Using the MOVE Index, a proxy for U.S. bond market volatility, we see a similar relationship. Low bond volatility has been associated with higher multiples. In months in which volatility has been below the already repressed post-crisis average, multiples on the S&P 500 were roughly 18, versus 16 when volatility was above average. While you’d expect multiples to be higher when the bond market is calm, the relationship was not nearly as strong in the pre-crisis world.

Why does this matter? It matters because negative term premiums and repressed volatility are unique features of the post-crisis environment. They are also both related to the Federal Reserve’s (Fed’s) ultra-accommodative monetary policy. As the Fed removes monetary accommodation, it is unclear if these conditions are sustainable.

Common sense would suggest that just as building up the Fed’s balance sheet compressed the term premium and suppressed volatility, the reversal should have the opposite effect. What is less certain is the magnitude. For now, investors seem to believe that any rebound in the term premium or volatility will be modest and slow. If that proves wrong, expect lower multiples and a less benign environment for stocks.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.


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