Here’s why

The S&P 500 rose 0.2% last week to close at 2945.64, and is off to its best four month start to a year since 1987. The Dow Jones Industrials is off to its best four month start since 1999. Some of you might remember what happened later in 1987 as well as in 2000. Reversion to the mean is one of the strongest constants in investing and it’s usually a mistake to “bull up” after a sharp rise in the market. Of course, there’s always the exception to the rule that invariably makes Mr. Market the ultimate trickster.

Earnings continue to come in better than expected, although not good by any stretch of the imagination. Three quarters of the companies in the S&P 500 have reported and Q1 earnings growth is running 0.9% so far, much better than the expected decline of 3.8% prior to the start of earnings season, but not the type of growth that will support a forward P/E multiple of 17 for long. The Bloomberg consensus is for annual earnings growth for 2019 of only about 2.5%, which would increase S&P 500 earnings to $166 in 2019 from $161.93 in 2018. First quarter sales are expected to increase by 5.1%, according to Barron’s. Real 2019 GDP growth is currently expected to increase by 2.4% in 2019, according to the St Louis Fed, which means nominal GDP will rise by about 4.4%, assuming inflation runs 2% in 2019. However, M2 growth was only 3.53% over the trailing twelve months and M2 has fallen slightly since the beginning of April, according to the St Louis Fed. Nominal GDP tends to track the growth in M2. Therefore, it’s likely that either real GDP growth will be less than expected in 2019 or inflation will be lower than expected. In fact, the Fed’s favorite indicator, the core Personal Consumption Expenditure Index (PCE) was unchanged for the month of March and up only 1.6% year-over-year, well below the Fed’s inflation rate target of 2%.

The drop in interest rates since last fall makes sense given slowing M2 growth (outright contraction?) and what it portends – either slower economic growth, lower inflation, or both. What also makes sense is the Fed Fund’s futures market now pricing in a 66% chance of a Fed rate cut by December of 2019, up from 52.5% just last week. 

Of course, the big news last week was the unemployment number, which fell to 3.6% from 3.8%. There are numerous reasons to believe employment isn’t as strong as indicated by the drop in unemployment, not the least of which is the decline in the workweek to 34.4 hours from 34.5, which is the equivalent of 373,000 jobs, according to Gluskin Sheff chief economist David Rosenberg. “Aggregate hours worked have dipped in two of the past three months and have been flat since the beginning of the year,” he goes on to write in a note to clients. Furthermore, underemployment (U6 in Bureau of Labor Statistics nomenclature) was unchanged at 7.6%. Something else to remember is that jobs are a lagging indicator… 

Historically, most of the returns to stockholders have come in the form of dividends. The S&P 500 has returned a bit more than 6.5% annually in real terms (adjusting for inflation) since 1871. About two-thirds of those returns were from dividends and the other 2.3% or so came from earnings growth. Dividends matter and it might help to review the basics of stock ownership to understand why.

You buy a part of a business when you buy a stock. You are entitled to your share of the profits. Those profits can be returned to you as a dividend. Profits can also be used to buy back stock, which increases your ownership in the business and entitles you to a greater share of future profits. Management can also elect to reinvest profits in the business, hoping to make investments that generate a positive return on investment (ROI). New companies, especially in new industries, often are able to substantially grow profits through reinvestment. However, every company has a life cycle that eventually results in fewer growth opportunities and lower returns on investment because of the law of diminishing returns. At some point, stockholders are better off if profits are returned to them through dividends, allowing owners to make their own capital allocation decisions. There is substantial academic research to suggest that management frequently destroys wealth when it fails to realize that growth opportunities are insufficient and that returning profits to owners is a better use of capital.

We like companies that pay a dividend. We especially like companies that are undervalued and pay a dividend. We earn the dividend while we wait for Mr. Market to realize its mistake. We earn a capital gain from the stock price returning to fair value. We earn an additional capital gain from the increase in fair value due to earnings growth during our holding period as well.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist