Reed Between the Lines: The Ingredients to Market Performance
By: J. Reed Murphy, CIO
Contributions by: Rob Young, CFA
Earnings? Dividends? Or Valuations? What Ingredients Really Matter?
Cooking is a skill and for some people it’s a passion—a therapeutic outlet. Meal preparation involves many variables including ingredient selection, available tools and technique. To the literal end- consumer, performance is based on taste; with all other contributing variables being negligible. After all, if a meal is satisfying, then who cares how it was made? Well, most people don’t.
Investing in the U.S. equity market can be viewed through a similar lens. At the end of the year an investor can look back and assess whether what the market served up was good or bad. After the initial reaction, a market connoisseur may wonder what the primary contributors to their performance were AND are those contributors expected to last?
Let’s take a closer look and read between the lines. How do the components of stock price, earnings per share, dividend and valuation multiple combine to give us bottom line performance? The following exhibit illustrates the contributors to various return scenarios.
EXHIBIT 1: RETURN SCENARIOS
Source: Calamos Wealth Management. Note: This is a hypothetical example to be used for illustrative purposes only. Hypothetical performance is no guarantee of future results.
- Year 1 – The stock price is $100. With $10 in earnings, the Price to Earnings ratio (i.e., multiple) is 10X ($100 stock price divided by $10 in earnings).
- Scenario 1 – In year two we assume the following; 1) Dividend grows at 5%, 2) EPS Growth grow at 5% and 3) the PE Multiple stays constant at 10…THEN the price increases commensurately at 5% ($105 from $100).
- Scenario 2 – In year two we assume; 1) Dividend grows at 5%, 2) EPS Growth grow at 10% and 3) the PE Multiple stays constant at 10….THEN the price increases by 10% ($110 from $100).
- Scenario 3 – In year two we assume; 1) Dividend grows at 0%, 2) EPS Growth grow at 0% and 3) the PE Multiple increases to 12 …THEN the price increases commensurately at 20% ($120 from $100).
RETURN CONTRIBUTORS VARY YEAR-TO-YEAR
As just reviewed, the three primary mathematical components of a stock (or market) price movement are; 1) Earnings per share (EPS) growth, 2) Dividends and 3) Valuation Multiples (Price to Earnings Ratio). From 1955 to 2019, the contributors to the S&P 500 performance came from the following (total equals 100% per year).
- Earnings Per Share (EPS) Growth – accounted, on average, for 63% of the return on a calendar year basis
- Dividends - averaged 28% of the return
- Valuation Multiple (Price to Earnings Ratio) Expansion or Contraction Contribution - averaged 9% of the return
However, when we look at the variance of the annual contributions of those components there is a dramatically different story. First, while over the long-term the valuation multiple showed the lowest contribution level, its contribution level on an annual basis varies dramatically. It has the highest variation of outcomes (i.e., highs and lows). This translates into significant swings in market returns from year-to-year.
Second, dividends are rather constant with a standard deviation (variance of data points around its average) that is very tight relative to Earnings per Share Growth and Price to Earnings Valuation Multiples. Said another way, the variance in highs to lows is tight with a low standard deviation and vice versa.
EXHIBIT 2: STANDARD DEVIATION IN CONTRIBUTORS
Based on an examination of these contributions on an annual basis, it is easy to surmise companies that pay dividends, in general, tend to be less volatile than companies that do not. Due to the compounded return impact of dividends and the assumption that those dividends are reinvested, the result is that dividends represent 86% of the cumulative return of the S&P 500 since the beginning of 1955 through 2019. (Bloomberg; Past performance is no guarantee of future results.)
SO, WHAT TO DO?
While all of this seems rather technical, evaluating this in context of where the market’s return came from over the last few years is enlightening. The S&P 500 return for 2019 of 31.5% was the best annual return since 2013, but the ingredients of its return profile was as different from 2018 as my cooking is relative to a Le Cordon Bleu-trained chef. In 2019, nearly 92% of the return was driven by an expanding valuation multiple (i.e. investors paid a higher-dollar-value-per-unit of income). In 2018, the opposite occurred with earnings growth flaring up and valuation multiples acting as a flame retardant (Exhibit 3).
EXHIBIT 3: S&P PERFORMANCE CONTRIBUTORS VARY YEAR-TO-YEAR
Source: Calamos Wealth Management. Bloomberg. Periods analyzed December 31, 1995 – December 31, 2019. Earnings Growth = Earnings per share growth year-over-year. Dividend yield is the annual contribution of the dividend yield reinvested. S&P 500 index is an index of the 500 largest corporations by market capitalization listed on the NYSE or NASDAQ. Past performance is no guarantee of future results.
As we look to 2020 we believe the following provides a base case scenario.
- Valuation Multiples –
- Price to Earnings (PE) valuations are above average. As of February 11, 2020, the S&P 500 Forward PE was 19.3x relative to a 25 year average of 16.3x (Bloomberg). However, the current low interest rate environment suggest higher Price to Earnings (PE) multiples are warranted, at least historically based. Naturally, there are numerous other factors that go into this assumption.
- Holding valuation levels constant at current rates based on the macro-environment is a good baseline expectation. However, as we have noted the variance in Price to Earnings Multiple can vary widely as news events unfold and markets react.
- Earnings per Share (EPS) Growth –
- Expectations for returns for the S&P 500 in 2020 may best be accounted for through earnings growth.
- At year-end (2019) EPS growth estimates for 2020 was 9.5%. However, according to FactSet, as of February 7, 2020, those estimates have come down to 8.3%. This mark down is consistent with historical trends as the year progresses (i.e., estimates come down). So, earnings growth of 7% to 8% could translate to market return expectations for the S&P 500. This market return would include dividend yields, which are currently at 1.78% for the S&P 500 (Bloomberg).
As we consider these elements on a forward looking basis, it is important to note that investors may be well served by international equity exposures. These markets are cheaper on an absolute and relative basis with higher dividend yields and earnings growth expectations overall; perhaps to further our beginning analogy – these exposures provide the spice to what could be another year in the markets to potentially savor. Please consult our full market commentary for our broader views on the markets and investment implications.