Intro: Equity markets are driven by the dividend yield, growth in dividends, and changes in how much investors are willing to pay for future dividends (changes in the dividend yield). Factors such as sentiment and trend following drive changes in dividend yields, while dividend growth is a product of economic and corporate fundamentals.
Equity market returns over any period are driven by three factors:
- Dividend Yield (income)
- Dividend Growth (capital gains due to fundamentals)
- Change In The Dividend Yield (capital gains due to valuation changes)
Dividends do not receive the attention they deserve in financial media as most of the focus is on earnings. Of course, the higher earnings are, the more companies will be able to pay out in dividends, but it is dividends themselves that investors ultimately receive. Certain companies or indices may pay no dividends, particularly if they are in their early stages and are using their cashflows to expand. However, such companies should be valued based on their ability to return cash to shareholders in the future.
Companies often prefer to return money to shareholders via buybacks, which involve using corporate cash to retire shares and therefore raising share prices. However, for an equity market as a whole, net buybacks tend to be fairly minimal contributors to equity returns as they are used to offset dilution from stock and option grants to corporate insiders.
The dividend yield performs a duel role in terms of understanding the outlook for equity returns; it tells us firstly what yield you will receive on an equity or index, and secondly, it tells us whether there are prospects for capital gains as the dividend yield falls or capital losses if the dividend yield rises. A high dividend yield therefore gives both high income and potential for large capital gains, and vice versa.
Changes in the dividend yield are driven by factors such as market trends and sentiment which drives how much investors are willing to pay for any given level of dividends. Fundamental factors such GDP and corporate fundamentals determine the rate of growth of dividends over time
Technicals: The Trend is Key
Equity markets have a tendency to trend in repetitive patterns. ‘The trend is your friend’ is one of the more useful market adages. Turning points tend to also exhibit recognizable patterns. When it comes to market troughs, for instance, we often observe downward spikes in price action, with a high level of correlation across individual stocks and very oversold momentum. This often corresponds with a spike in implied volatility, reflecting a high level of fear in the market.
Market peaks, on the other hand, tend to exhibit rounding out patterns, with the number of individual stocks hitting new highs declining as the market advances. It has been said that equity market bottoms are an event, while equity market tops are a process. It is also common to see divergences across risk assets. For example, peaks in the Dow Jones tend to be preceded by peaks in the Transportation Index (Dow Theory), or other cyclical equity sectors.
Sentiment: Be Greedy When Others are Fearful
Sentiment refers to both equity market and economic sentiment, which reflect the prevailing consensus with regards to the outlook for equity prices and the economy. The prevalence of negative sentiment makes it more likely that economic or corporate sector results actually beat expectations, and vice versa, meaning that sentiment should always be considered as a contrarian indicator. The more bearish investors and economists are, the higher the likelihood that they will be surprised to the upside and thus increase their demand for equities.
Fundamentals: GDP Growth Only Part of the Story
Real GDP Growth: The outlook for economic growth is a key driver given that corporate sector fundamentals cannot grow faster than GDP indefinitely. Because equities themselves tend to provide a leading indicator to real GDP growth, only the fundamental/medium term growth outlook can really be used to help predict equity returns.
Corporate Profits: It is also important to assess the outlook for corporate profits independently, because as we have seen in recent years corporate profits and GDP can diverge considerably during times when the labour market is weak and wage costs tend to rise more slowly than profits.
Debt: The level of indebtedness is another key driver of earnings growth. If the corporate sector has very little debt, this means there will be low interest costs and greater potential for companies to expand organically or engage in buybacks.
Monetary Policy: Activist monetary policy that keeps interest rates below inflation will tend to encourage debt-financed buybacks.
Fiscal Policy: Fiscal policy aimed at keeping corporate tax rates low will tend to support corporate earnings, all else equal.
Corporate Governance: This is particularly important for emerging markets whose equity indices are dominated by partially state-owned enterprises, as poor corporate governance can result in decisions being made that are not in the interests of profitability and shareholder returns.