"The election. The fiscal cliff. The national debt. The federal deficit. Agonizingly slow economic growth. Chronically high unemployment. Superstorm Sandy, the east coast’s Katrina. The euro plague, leapfrogging from Greece to Spain, next perhaps to Italy and even France. The weak dollar. The Federal Reserve continuing to push on a string. The China slowdown. The LIBOR scandal. The Facebook IPO fiasco. The Knight Capital mini-flash crash. Yet another new strain of flu virus. The end of the world foretold by the Mayan calendar (and almost hourly on CNBC). 2012 was certainly a banner year for catastrophism, was it not?
How very odd, then, that the broad equity market—which started the year at 1277 on the S&P 500 and ended it at 1426—so signally failed to get the message. With dividends, it returned something close to 14% in this seemingly most relentlessly dismal of years. How shall we account to ourselves for this dichotomy, which seems on its face not merely inexplicable but downright contradictory? Well, I can think of two possible explanations.
The first and most obvious is that the stock market was just dead wrong: that it recklessly ignored the plethora of real and impending disasters that are bearing down on us with each passing day, and which will surely swamp our economy and precipitate a market meltdown … any day now. For simplicity’s sake, let’s call this Door Number One: Pessimists Right, Market Wrong.
But then there’s that other possibility. Which is, of course, that the pessimists have not just been momentarily wrong: they’ve been fundamentally—and perhaps fatally—wrong about the whole equation. They have, in short, been focusing entirely on the fiscal, monetary and economic mistakes of countries. But the equity market—as is its wont—has been much more narrowly focused on the variables that always ultimately drive it: the healthy, growing (and by some measures record-breaking) earnings, cash flows, dividends and cash positions of companies. We’ll call this, as I’m sure you’ve already anticipated, Door Number Two: Market Right, Pessimists Wrong.
This is just one armchair observer’s opinion, you understand, but—as I have all along—I’m going with Door Number Two. And thereby hangs a tale.
It is fashionable in pessimist circles to note that the equity market as denominated in the Standard & Poor’s 500 stock index closed out 2012 just a tad below where it ended 1999, in the mid 1400s—having all these years “done nothing.” This observation is only narrowly correct if one ignores dividends, but that’s what pessimists like to do.
More important, of course, is the fact that at the close of 1999 the market was within weeks of the bitter end of its greatest two-decade run of all time, during which the index went up quite a bit more than 10 times. It was at that point, by any and perhaps every measure, way ahead of itself.
One might also observe that the market stands roughly where it was at the end of 1999 by virtue of having absorbed and then overcome the two biggest bear markets of the post-WWII era: the 30-month, 49% howler of 2000-2002 following the bursting of the tech bubble, and then the 17-month, 57% mother bear of 2007-2009, driven by the complete collapse of the global financial system. That the market is anywhere near its levels prior to the nightmares of these dozen years is, in fact, as ringing an endorsement of equities’ resilience as anyone could realistically ask for.
But by far the most important forward-looking realization is that while the index may have been, on net, treading water for these unlucky 13 years, its earnings and dividends have essentially doubled. (As the late American philosopher Charles Dillon Stengel always said: “You could look it up.”) OK, technically the earnings have a bit more than doubled, and the dividends have a bit less, but the point is made: the prices of the great companies in America and the world relative to their earnings and dividends have to all intents and purposes halved, lo these 13 years past.
We must therefore consider the possibility that the market may in these 13 years have gotten almost as far behind itself as it was ahead of itself in 1999. And that what it did in 2012 was simply play catch-up.
And there is perhaps more to this thesis than most investors may suspect. At the end of 1999, the S&P 500 was completing a year in which it earned about $50. Dividing those earnings by 1450, the index’s earnings yield stood at 3.5%—at a moment when the yield on the 10-year U.S. Treasury bond (though falling rapidly) was still around 5%. It could have been argued (and in fact this thesis turned out to be the correct one) that the bond was the better value, at the very least offering a very competitive risk-adjusted return.
Beginning 2013 near 1450, with trailing earnings in excess of $100, the S&P 500’s earnings yield was very nearly 7%, while the 10-year Treasury’s was 1.8%, suggesting that the relative values of stocks and bonds have very sharply reversed since 1999. And that’s not all.
Dig a little deeper, and we discover a couple of very intriguing facts about dividends. The more obvious of these is that—for only the second time since 1958—the current dividend yield of the S&P 500, at slightly higher than 2%, is greater than that of the 10-year Treasury. (The only other time this has happened was during the Great Panic of 2008-09.)
More obscurely but perhaps more importantly in the longer run, since 1871 the average dividend payout ratio—the percentage of their earnings that companies paid to shareholders as dividends—has been 53%. It’s currently 29%. This certainly doesn’t insure that companies will be significantly raising their dividends anytime soon. But it tells us that, at least historically, they have a lot of room to do so—or to buy back stock, which is simply enhancing shareholder value by another means.
Set aside the staggering economic progress of the developing world—China, India, Brazil, Mexico and the like—in these 13 years. Set aside the fact that, through the glorious operation of Moore’s Law, the cost of computing has fallen by something like 98% since 1999, thereby empowering the rise of a billion global smart phone users. Set aside the stunning reality that the United States has gone from abject dependence on foreign oil to a point where it will emerge as the world’s leading oil producer by 2020.
And set aside, if you can, the inarguable fact that the fiscal conditions of the West’s democracies are an unholy mess. Tocqueville said it 170 years ago, and it’s never been truer than it is today: “A democracy will always vote itself more benefits than it is prepared to produce.” Set this aside, I say, because as they become almost daily more genuinely global, the great companies become progressively less dependent on the economies of the older democracies on both sides of the Atlantic. At his confirmation hearings in 1953, President Eisenhower’s nominee for secretary of defense could opine (if not in so many words) that what was good for General Motors was good for this country. In 2013, General Motors will sell as many cars in China as it does in the United States. This is not your father’s Oldsmobile, and it isn’t his stock market, either.
2012 was a year in which everybody who based their investment policy on the litany of disaster recounted at the beginning of this essay cut back their exposure to equities—or fled them altogether—and got royally skunked. While everyone who tuned out all that noise and stayed resolutely focused on the earnings, cash flows and dividends of equities—on their own merits, and especially compared to bonds—prospered.
To say that returns over the next 13 years are not going to be exactly like those of the last 13 is, at least in the case of bonds, to express nothing more or less than a mathematical certainty. I would venture a bit beyond that, invite the roughly 40 million Americans heading into retirement during these next 13 years to consider, at the very least, the possibility that this next block of time might actually end up being the mirror opposite of the last one."
© 2013 Nick Murray. All rights reserved. An earlier version of this essay appeared in Nick’s newsletter, Nick Murray Interactive. To download a sample issue, please visit www.nickmurray.com, and click on “Newsletter.”