{"id":340,"date":"2013-01-18T18:23:52","date_gmt":"2013-01-18T18:23:52","guid":{"rendered":"http:\/\/www.wallstreetandkstreet.com\/?p=340"},"modified":"2013-01-18T18:26:15","modified_gmt":"2013-01-18T18:26:15","slug":"valuation-levitation","status":"publish","type":"post","link":"https:\/\/www.wallstreetandkstreet.com\/?p=340","title":{"rendered":"Valuation Levitation?"},"content":{"rendered":"<p>For the past four years I have been asking: \u201cWhy do so many investors want to own a bond that pays 2% when they could own a basket of blue-chip stocks with a dividend yield of over 3% <strong>AND<\/strong> the dividend stream is growing 10% per year <strong>AND<\/strong> dividends are taxed at a lower rate than interest income?\u201d\u00a0 Two answers:<\/p>\n<ul>\n<li>They preferred bonds because they were just plain scared by (take your pick), the U.S. financial crisis, the European financial crisis, the slowdown in China, worldwide deflation, Barack Obama, fiscal cliffs.<\/li>\n<li>Bond yields were falling and prices rising, so they could make good money in bonds even though there were overvalued.<\/li>\n<\/ul>\n<p><b>Back to the Future?<\/b><\/p>\n<p>Now the psychology is starting to change, because macro-disasters have not materialized and bond yields are rising. The market senses that, with rates so low and dividends set to keep growing, investors could decide that stocks deserve a materially higher valuation despite slow economic growth, recession in Europe, Barack Obama in the White House, etc.<\/p>\n<p>That\u2019s what occurred in the mid-1980s.\u00a0 The bull market started in August 1982, with stocks soaring 50% from June 1982 to June 1983.\u00a0 But then the Fed started to tighten and investors worried economic growth would reignite inflation.\u00a0 So stocks were flat for eighteen months, until the end of 1984.\u00a0 At that point the economy slowed, inflation stayed low, and investors concluded we were not returning to the bad old days of double-digit CPI\u2019s and single-digit PEs.\u00a0 Over the next two years <b>stocks rose 45% even though profits were terrible<\/b>, declining 5% in 1985 and rising just 1% in 1986.\u00a0 The S&amp;P 500 trailing PE on pro forma EPS rose from 9.8x at year-end 1984 to 14.8x at year-end 1986. (Admittedly the PE was boosted by abnormally weak profits in 1986, when oil prices and oil company profits collapsed.)<\/p>\n<p><b>S&amp;P 1864?\u00a0 I\u2019ll Take It<\/b><\/p>\n<p>We don\u2019t need a huge five point rise in PE\u2019s to get some pretty nifty gains in stock prices.\u00a0 Suppose profits are $107 this year and rise just 6% in 2014 to $113.\u00a0 Stocks now trade at a trailing PE of 14.4x, based on 2012 EPS of $103.\u00a0 If by year-end 2014 the trailing PE is 16.5x, the price would be 1864 (16.5 x 113), 26% above today\u2019s price.\u00a0 A PE of 16.5x is not at all implausible if investor confidence in equities improves and bonds no longer look to be a one-way bet; the average PE in 2005 and 2006, when interest rates were much higher than now, was 16.3x.<\/p>\n<p><b>The Dividend Driver<\/b><\/p>\n<p>With investors thirsting for yield, a key driver of this PE expansion would be rapid dividend growth as profits grow slowly but the dividend payout ratio rises toward 35%, which would still be far below the payout ratios in Europe today or in the U.S. in the past.\u00a0 (The 1985-94 average was 48%.) \u00a0Last year dividends were $31.24, or 31.2% of profits of $103.\u00a0 At a current price of $1480 stocks yield 2.1% on that $31.24 DPS.\u00a0 If profits are $113 in 2014 and the payout ratio rises to 34%, dividends would be $38.42.\u00a0 If the yield on the market remained at today\u2019s 2.1%, the price of the S&amp;P 500 would be 38.42 \/ .021 = 1830, 24% above where we are now.<\/p>\n<p><strong>Risks<\/strong><\/p>\n<p>This scenario is hypothetical and unscientific, but perfectly plausible.\u00a0 Just as investors became less fearful of inflation in 1985 and 1986, they may become less fearful of deflation now, driving PE ratios higher despite mediocre near-term profit growth.\u00a0 Even modest PE growth combined with modest profit growth can produce impressive stock price increases.<\/p>\n<p>Probably the biggest risk to this scenario is\u00a0renewed crisis in Europe; financial, political, and media elites cannot paper over the dire condition of the real economy forever. \u00a0Eventually unemployed workers in Spain, Italy and France may bite back. Perversely, Draghi\u2019s accommodative stance has taken pressure off governments to make structural reforms.\u00a0 Another non-trivial risk is that Obama\u2019s reckless fiscal policy overwhelms Bernanke\u2019s bond-buying spree, undermining confidence in U.S. debt.<\/p>\n<p>Copyright 2013 Thomas Doerflinger.\u00a0 All Rights Reserved.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>For the past four years I have been asking: \u201cWhy do so many investors want to own a bond that pays 2% when they could own a basket of blue-chip stocks with a dividend yield of over 3% AND the &hellip; <a href=\"https:\/\/www.wallstreetandkstreet.com\/?p=340\">Continue reading <span class=\"meta-nav\">&rarr;<\/span><\/a><\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[1],"tags":[22,56,77],"class_list":["post-340","post","type-post","status-publish","format-standard","hentry","category-uncategorized","tag-dividends","tag-stock-market-history","tag-stock-market-valuation"],"_links":{"self":[{"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=\/wp\/v2\/posts\/340","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcomments&post=340"}],"version-history":[{"count":4,"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=\/wp\/v2\/posts\/340\/revisions"}],"predecessor-version":[{"id":345,"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=\/wp\/v2\/posts\/340\/revisions\/345"}],"wp:attachment":[{"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=%2Fwp%2Fv2%2Fmedia&parent=340"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcategories&post=340"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=%2Fwp%2Fv2%2Ftags&post=340"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}