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Dividends, Earnings Growth and PEs: Three Strikes for Stocks?

The markets took a sharp dive Monday morning after Standard & Poor's downgraded its outlook on U.S. debt, but stock market sentiment is still at or near the most bullish level in many years. If the S&P move doesn't provide enough of a reality check, then here's another one from the latest issue of the No-Load Fund Analyst. The caution displayed in the newsletter, published by the Litman/Gregory portfolio management firm, offers further encouragement for the many bullish investors out there to rein in their enthusiasm.

The editors emphasize three factors when formulating their long-term outlook - dividends, earnings growth and changes in price-earnings ratios - and all three give them much cause for concern. Here are their thoughts on each:

Dividends. "Today's dividend yield is very low, so low that even strong growth in dividends paid will not make the divi­dend yield a huge contributor to returns over the next five years. [The Standard & Poor's 500-stock index] yields about 1.8 percent. Compare this to the 25-year average of 2.3 percent and the 50-year average of 3.1 percent. Bull markets in the past have always begun with higher-than-average dividend yields. Since 1926, the only time the dividend yield was lower than it is now was during the period of elevated stock valuations during the late 1990s and early 2000s. It's easier to capture strong returns over multiyear periods when more of the return comes from dividends."
Forecast: One Big Dark Cloud
Earnings growth. "Earnings have rebounded powerfully since the very deep trough in 2009. This rebound has been driven by cost cutting and government stimulus (neither of which will be sustained) and emerging markets' growth, which we believe is likely to be sustained (though inflation in emerging markets presents a serious risk). Our scenario work suggests that, despite the sharp rebound in earnings, growth is likely to be subpar as the rest of the cycle unfolds. Subpar economic growth is consistent with histor­ical outcomes in the aftermath of a financial crisis.
"This history dovetails with a key assumption influ­encing our analysis - that the excessive private and public debt cloud hanging over the economy will result in continued deleveraging and therefore a lower level of consumption than would otherwise be the case. Private debt has declined from its peak but remains historically high, while public debt has spiked higher and will continue to increase given growing entitlement costs as baby boomers age."
These thoughts on earnings were accompanied by a chart (which was not given permission to reproduce) showing the relationship between nominal gross domestic product and pretax corporate profits. The line representing the latter has remained below the GDP line for nearly all of the last 60 years. When the earnings line converges with the GDP line and begins to flatten out, as in the mid-1960s and mid- and late 1970s, it has nearly always been a good time to sell stocks.

The earnings line went right through the GDP line in the middle of the last decade, but the point at which it began flattening again was close to a market top. Earnings plunged during the credit crisis and then snapped back, bringing the two lines together one more time. It's too early to tell whether the ominous flattening is occurring, but the long-term pattern would make any rolling over of earnings very worrisome.

Running the Gamut From Low to Lower
Change in PE ratios. "Our forecasts are influenced by historical PE ranges with attention paid to PE levels in various types of economic and market envi­ronments. In our scenarios, PE assumptions range from 12 times earnings to 18 times earnings. . . . This all nets out to a wide annualized return range for stocks of -8 percent to 11 percent. . . . While this is the broad range, we believe the evidence suggests stock market returns are likely to come in around the midpoint of this range - in other words, low single digits."
The editors point out that the "normalized" market PE ratio, meaning adjusted for changes in the economic cycle, has been higher than it is now in only four other periods - the 1920s, mid-1960s, late 1990s and mid-2000s. Each period was followed by a long period of severe weakness in stocks.

Their analysis tells them that the market can go either way and to greatly varying degrees, but of the many possible futures, they're not betting on a benign one:

"As we look ahead, we continue to see an unusually wide range of possible outcomes for the economy and stock market. The weight of the evidence continues to suggest mediocre to low returns for the financial markets over our five-year time horizon. We remain cautious and somewhat defensive."

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