Stocks can decrease in value for any number of reasons -- many of which don’t make a whole lot of sense. Hillary Clinton tweets about drug pricing and all Healthcare stocks decline in value. The Fed raises rates and stocks go... up? Wait, and then the Fed raised rates too soon -- so now stocks go... down? Then oil prices collapse, which means the largest part of the U.S. economy (consumers) is now doing better. Sell, sell, sell!
The manic depressive behavior of the stock market is maddening. That’s why you can drive yourself nuts checking your account five times a day. It’s going to be up and down -- sometimes for no apparent reason.
But let’s take a step back here and get back to the basics. What is a stock? It is ownership shares in a real, tangible business. If stocks represent companies, the real question is not what the stock market says they are worth. The real issue is: What are the underlying companies worth?
If you own your own business, its value to you is represented by one thing: How much cash that business produces for you each year. Let’s say your company produces $10,000 per year in cash profits. The year after that, it generates $12,000. Then $15,000. Then $20,000.
What is happening to the value of the business? It’s going up, of course.
On the other hand, if your $10,000 profits fall to $8,000 then $6,000 then $0 -- what is the business worth? Well, not much. You’d be better off in a checking account.
The stock market is down by 12% to start the year. Traders have decided that U.S. businesses are now worth 12% less than they were just 42 days ago. Does that make any sense to you? Is it possible that companies have lost more than a tenth of their earnings power in just 1.5 months?
So if we can’t rely on the stock market to value businesses, on what do we rely?
Where Real Company Value Comes From
Going back to 1960, our valuation models indicate that dividends and earnings can explain more than 90% of the annual movements of stock prices. That means 10% of the market’s movements is just “noise” -- shouting broadcasters on Fox news, tweets from political leaders, and the latest news flash.
The 10% is what we see every time we check our account statements. It’s either + or - some number. But that’s not reality. The reality is in the 90%: the dividends and earnings. Over an extended period, these two forces will drive stock prices either higher or lower.
So what has happened to the real value of U.S. businesses over the past 1.5 months? Let's look at what drives value: dividends and earnings.
Since the beginning of 2016, the dividend announcements for S&P 500 companies has been impressive.
Companies in the S&P 500 have increased their dividends by 0.7% so far in 2016. That’s on pace for 6.2% annual growth. That rate of increases isn’t impressive, but remember that many Energy companies are cutting their dividends. So the rest of the sectors are doing quite well.
Perhaps more importantly, the dividend estimates have been coming in about in line with expectations. Unless we start to see disappointing announcements, dividend growth appears stronger than the long-term average of 5.5%.
If dividends aren’t declining, falling stock prices must be mirroring earnings. Dividends come from earnings, so a sharp drop in earnings will impact a company’s ability to pay and grow dividends in the future.
By our calculations, the market is pricing in a 24% decline in earnings for 2016. If other investors expect a reduction of that magnitude, where will it come from?
The most obvious place is Energy and Materials. These sectors’ earnings declined 57% and 15%, respectively, in 2015. If they repeated that performance in 2016, that would drag down the overall S&P 500’s earnings by less than 4%.
OK, so a 24% decline in earnings isn't solely from Energy and Materials. Where else will it come from? For another 20% decline in earnings, we need widespread earnings recession across all sectors.
But we’re not seeing that.
The Consumer Discretionary earnings continue to be strong (+15% year-over-year). Excluding the dollar’s impact, Consumer Staples companies are reporting impressive numbers. Healthcare continues to be a bright spot despite political issues (+12%). Utilities (+4%), Technology (+7%), and Telecom (+16%) are also showing strong earnings growth.
Patches of the Industrial sector have seen earnings expectations decline, but overall -- the industry still reported positive year-over-year growth in the most recent quarter. The lower expectation for Fed rate hikes has hurt the Financial sector, but not enough to drag down the S&P 500’s earnings by 20%.
When you add it up, the overall expectations for earnings are diminished, but not by anywhere close to what the market has priced in. As of February 15th, earnings expectations had declined by 3% in 2016. That’s not enough to warrant what we’ve seen from stocks.
If dividend and earnings are still largely intact, we can conclude that the fundamental value of U.S. businesses is relatively unchanged. If that’s the case, then the market’s 12% drop for 2016 has been mostly driven by “headline risk” rather than real decay in fundamentals.
As an investor in stocks, you can’t focus on the market prices on a daily basis. That’s maddening.
Ask yourself two questions:
1) Do I believe that U.S. corporations are going to be earning more money in 10 years?
2) Do I believe that those companies will be paying out more cash dividends in 10 years?
If the answer to both of those questions is “Yes” -- you will be rewarded for owning dividend paying stocks. Over the long term, higher earnings lead to higher dividends, which leads to higher value of the companies that pay them. The stock market prices will have no choice but to follow.
We can’t know what tomorrow holds. The stock market could be in a good mood, or it could be in a bad mood. What we can know is that dividend payments will continue to be paid. And those checks will continue to grow each and every year. As long as this continues, these market gyrations don’t make a difference for disciplined investors.