Will dividends push the S&P 500 (SNPINDEX:^GSPC) up to 3,000 -- roughly 50% above its current level -- before the end of the decade? That is the argument Dominic Rossi, Fidelity's global chief investment officer for equities, made in yesterday's Financial Times. It's worth taking a few minutes to deconstruct his argument to gain a better sense of what dividends can and can't do for investors.
Dividend growth is highly prized
The thrust of Rossi's argument goes something like this:
- Savings are rising faster than income in the developed nations.
- Those savings are in search of yield in a yield-deprived world.
- The dividend growth of U.S. equities make them by far the most attractive destination for those savings.
- The resulting demand will support a low dividend yield on U.S. equities as dividends continue to grow.
So far, so good, but that is all "helicopter view" stuff. Let's look at some of the nuts and bolts of the assumptions behind the forecast:
Over the 15-quarter period, [S&P 500] dividends per share have averaged 14.2 per cent growth. It is little wonder the US equity market has been one of the most rewarding asset classes in recent years. Is this set to continue? We think so.
Fifteen quarters takes us back to the first quarter of 2011, at which time dividends were depressed, having fallen by a fifth relative to their pre-financial crisis high. Still chastened by the crisis, companies in the S&P 500 were paying out in dividends a nearly all-time-low proportion of their profits. That doesn't deter Rossi, however:
In contrast [to emerging markets, Europe, and Japan], dividend per share growth for the S&P 500 is likely to stay at double-digit levels. This is above earnings growth but the payout ratio is 32 per cent.
I couldn't verify the figure of 32% for the payout ratio (the numbers I derive are somewhat higher), but I assume the last sentence suggests companies have room to increase this ratio from its current level, which is below its historical average.
Let's not forget buybacks
However, if we add share buybacks to obtain a genuine capital return ratio, we find companies returned $0.95 of every dollar of profit to shareholders in the trailing 12-month period ending with the third quarter of 2014. Companies' flexibility to increase their dividend payout ratio might not be as great as Rossi suggested. But here's the crux of the forecast:
In the age of income investing, the income growth properties of the S&P 500 will continue to be highly valued. According to our estimates, S&P 500 dividends could exceed $48 by 2016 and $60 is not beyond reach by the end of the decade. If we assume a 2 per cent dividend yield, its 10-year median, the S&P 500 could exceed 2,400 before the next president is inaugurated. A level of 3,000 is within reach before the decade is out.
If S&P 500 dividends were to increase to $60 by 2019, that would indicate a 10-year annualized growth rate of 10.3%. The following chart, based on data compiled by Yale University economist Robert Shiller, shows the trailing-10-year growth rate in dividends for every month since January 1950.
The chart makes it quite clear that a 10-year growth rate in excess of 10% is exceedingly rare -- in fact, it has only occurred during a six-month period in the mid-1950s. In that light, a $60 dividend forecast looks very optimistic.
The trouble with the dividend yield
Finally, applying the dividend yield to estimated dividends five years out doesn't produce a robust forecast of the S&P 500. The dividend yield is a small number and inversely proportional to the index level, so small changes in your dividend yield assumption have a significant impact on your estimated index values.
Sure, a 2% dividend yield indicates a 3,000 forecast for the S&P 500 ($60/ .02 = $3,000), but is it hard to imagine a dividend yield at 2.25% instead? The latter puts the S&P 500 at 2,400 -- hardly a disaster, but a far cry from Rossi's rosy forecast. I'll let you calculate the implications if the dividend yield were to return to its 65 - year average of 3.3%.
I'm not foolish enough to assert the S&P 500 can't reach 3,000 by the end of 2019, but I think it's unlikely; either way, I don't find Rossi's argument convincing -- at least insofar as his numbers are concerned. On the other hand, he might be onto something with the notion that shares that offer a reliable stream of growing dividends will command a premium over the broad market for the foreseeable future.