The 4 Drivers of Stock Market Prices

We have found that very few investors understand what really drives the stock market.  In our view, the four primary drivers of market valuations are earnings, dividends, interest rates and inflation.  If you can quantify what is going on with those four variables, our models indicate that you can predict about 90% of the annual movement of stock prices.

Last time, we talked about the Barnyard Forecast which is a model that signals the probable direction of the market.  While the Barnyard Forecast does correctly predict the market’s direction 6 to 18 months from now with about 80% accuracy, it is not a short-term predictor nor does it have any valuation component.  Therefore, we use select valuation models to ascertain the relative attractiveness of stocks.

Almost all of these models use some component of the above mentioned variables.  Within those four variables, there are two that stand out above the others as being the most important drivers.  We’ll take a look at each factor and then conclude with what it means for stocks.

Earnings

Most investors look to earnings as the primary guide of what a company is worth.  In theory, that makes sense.  If Company A is earning $500 and Company B is earning $1,000 - wouldn’t you rather own Company B?

The problem with earnings is that they can be engineered by creative corporate executives.  In times of recession, earnings are particularly volatile. Earnings can be calculated in a variety of different ways, which adds additional complexity.  We don’t think earnings should be completely discounted in valuing companies or the stock market as a whole.  However, the unpredictable nature of earnings often gives very bad signals at turning points in the market.

Dividends

We have found dividends to work much better than earnings.  Over the past 50+ years, dividends have had approximately three times more predictive power than earnings.

Let’s say you own two rental properties.  One rents for $100 per month and the other rents for $200.  If both rents are increasing at 3% per year and both will continue to rent for the next 20 years, which rental property would be worth more to you?  The one that will pay you the most in rental income over its useful life… right?  

John Burr Williams was the first to apply this theory to stocks.  He said the value of a stock today is the sum of all future dividend payments discounted back at some required rate of return.  In other words, the more a company pays out to its owners in the future, the more valuable that company is to its owners today.  

Not only does that theory make “real world” sense, but it also holds up statistically.  In our models, we’ve found that dividends are the most important driver of stock prices by a wide margin.

Interest Rates

Interest rates are a primary concern for most stock investors.  The general level of interest rates essentially represents the “opportunity cost” of investing in stocks.

If your bank account were to start offering 10% per year on your savings account, you would probably prefer to “invest” in your savings account rather than in the stock market.  If your bank account is only paying 0.1%, however, the attractiveness of investing in stocks increases.

Many investors would be surprised, however, that interest rates are not the most important factor in determining long-term stock prices.  

Inflation

Inflation is actually a much more significant predictor.  How can that be? There are several reasons for this.

Interest rates can be artificially set by the Federal Reserve.  Inflation can be influenced by Fed policy, however, it is primarily a result of real world economic activity.

Inflation is also one of the primary drivers of interest rates.  If inflation is rising, it has the effect of diminishing the real rate of return for a bond investor.  In that environment, a bond buyer will demand a higher rate of interest to compensate for the loss of purchasing power.

In addition, inflation is impacted to a large degree by economic growth. When the economy is growing at a faster rate, the Federal Reserve will generally tighten monetary policy, which raises interest rates.

The importance of inflation is also reflected in several of our models.  We have a price-to-earnings (or “P/E”) Finder model that we use to determine the appropriate P/E ratio for stocks.  In that model, inflation has been a much better predictor of P/E than interest rates, GDP growth or earnings growth expectations.

Outlook for Stocks

If you can understand these four variables, you can get a fairly accurate gauge of the valuation of the market.  At this moment, all of these variables are very positive for stocks.

• Dividend growth for the S&P 500 has been over 10% year-to-date.  We believe this will continue to be strong in 2015.  Companies are beginning to understand how valuable their dividend checks are to shareholders and have begun to emphasize dividend growth as a priority.

• Earnings are expected to grow by over 10% in 2015.  Time will tell whether that will come true or not.  If it does, we anticipate the market will reward the companies for their continued strong performance.
• Inflation remains very low.  With little capacity pressure from either employment or plant and equipment, we don’t see much of a chance that inflation gets higher than the Fed’s target of 2.5%.  The economy is simply not growing fast enough.
• With inflation low and the Fed continuing their stimulative monetary policy, interest rates are likely to remain low.  The 10-year Treasury continues to trade at the low end of our 2013 prediction of between 2.5% and 3.0%.  We don’t anticipate that rates will get much higher than that over the near term.

As we talked about last week in our Barnyard Forecast, monetary policy conditions are very favorable.  Aside from a major geopolitical shock, stocks don’t face any major red flags going into 2015.

The most current reading from our S&P 500 valuation model indicates that the fair value of the market is about 1,950.  As this is being written, the S&P 500 is trading at about 1,952.  From both a directional perspective and a valuation perspective, our models are saying that stocks are still the place to be.

John Burr Williams and Chickens For Their Eggs

This is the third blog in a series exploring the theories of John Burr Williams. You can read the first post here and second post here.

In Part I of this series, we quoted Arnold Bernhard, founder of the Value-Line Investment Survey, as being an early advocate of the theories of John Burr Williams.  He agreed entirely with Mr. Williams’ belief that investors needed a generally accepted valuation criteria. He also joined Williams in warning that the effects of not having such a methodology had resulted in excess stock market and economic volatility over the years that had damaged investor confidence not only in the stock market but also in the free markets.

Bernhard boldly stated,

“In our own experience, during periods of inflation as well as at other times, in this country and abroad, it has been found that dividend-paying ability is the final determinant of the price of a common stock.  Whenever, over a period of years, the dividend or the ability to pay dividends, went up; so too did the price of the stock.  When the dividend-paying ability went down, so did the price of the stock, inflation or no inflation.”  

In applauding John Burr Williams’ theory; however, Bernhard inserted a subtle twist to Mr. Williams’ basic premise by adding the words, “ . . . or the ability to pay dividends.”  By adding just these few words, he reentered the world of earnings and left behind the “dividends only” world that Williams had described as so important in determining long-term intrinsic value.

The Dividend Theories of John Burr Williams, Part II: Investing versus Speculating

This is the second blog in a series exploring the theories of John Burr Williams. You can read the first post here.

John Burr Williams’ book, The Theory of Investment Value, was not about beating the market or getting rich in the market.  It was really a wake-up call to the investment elite to offer them a theory of investment value that would encourage more long-term investing and less speculation.  Williams postulated that investors’ inability to properly value stocks increasingly led them to become speculators. Most people would not admit that they were speculators, but it was clear by their decisions that they were not appraising the intrinsic value of companies but betting that they knew something that the market did not.

ABCs of Dividend Investing: John Burr Williams, The Father of Dividend Investing Still Speaks

Because we have long espoused John Burr Williams' theories of dividend investing, we are often asked why he focused on dividends and not on earnings in determining a stock's value.  This prioritizing of dividends ahead of earnings was controversial in 1937 when he published his book, The Theory of Investment Value, and it remains so today.

This is Part I of a series of three blogs in which we will describe who John Burr Williams was, why he believed dividends trumped earnings in determining the intrinsic value of a company, and finally, why his theories on economic growth matter so much today.

In 1937 near the end of the worst bear market in US history, Williams, a thirty-five year old Harvard doctoral student in economics, made the following statement in his thesis: 

“The investment value of a stock is the present worth of all future dividends to be paid upon it . . . discounted at the pure [risk less] interest rate demanded by the investor.”

Mr. Williams’ dissertation did not immediately earn him his doctorate.  That would not be forthcoming until 1940.  Prior to his final oral exam, he sold the rights to his thesis to Harvard University Press, who published his dissertation as a book, but only with Mr. Williams subsidizing a portion of the costs. 

It would seem that only a fool would sell his doctoral thesis before he had been granted the degree. Williams, however, who was already a successful Wall Street investor when he went back to Harvard, explained that he had returned to college to learn what had caused the 1930s stock market crash (and the subsequent economic depression) from the best minds possible.  Since he had come for the knowledge and not the degree, and since his work was complete, he wanted to share his findings with the public as quickly as possible. 

What he did not say at the time, but would later admit, was that because of some of the views he had expressed in his thesis, he had become persona non-grata with key Harvard professors and was unlikely to have been awarded the degree anyway. 

Blaming the Bureaucrats 

His troubles with the dons of the school of economics were many but were centered in two areas: (1) Williams claimed that the correct method for determining the intrinsic value of a company was by calculating the present value of its future dividend payments, not earnings as was the universal belief at the time, and (2) he voiced great skepticism of the theories of John Maynard Keynes and the New Deal programs of President Franklin Roosevelt.  Williams devoted an entire chapter in the book entitled "Taxes and Socialism" to debunking the notion that the redistribution of wealth could lead a country to prosperity.

Finally, in 1940, with the book drawing praise from important financial commentators, and his success as an investor gaining accolades, John Burr Williams went before the Harvard dons to seek his doctorate. 

As expected, he was soundly criticized for publishing the thesis before he had obtained his doctorate, and his professors were upset that he did not embrace Keynes’ teachings. Oddly enough, however, they did not dispute his dividend-centric theory of investment value but questioned if a thesis studying the valuation of stocks had enough significance to justify a doctorate in economics from Harvard.  After a heated debate, he was granted his doctorate. 

The truth is often born of travail, matures under constant testing, and once acknowledged, is subject to twisting.  That has certainly been the case with John Burr Williams’ theory.  What had angered his Harvard professors, at first, caused Wall Street brokers to scoff.  The majority of the wizards of Wall Street believed then, as they still do today, that earnings are the driver of stock prices and that dividends are only a by-product.  Furthermore, intrinsic value has never commanded a big following on Wall Street, where trading and short-term speculation have long been the accepted modus operandi. 

Blaming Wall Street 

A closer reading of the book, however, turned Wall Street’s ridicule to scorn.  The ways of Wall Street were being blamed, at least partly, for the stock market crash.  Williams' thesis stated the following: 

“The wide changes in stock prices during the last eight years, when prices fell by 80% to 90% from their 1929 peaks only to recover much of their decline later, are a serious indictment of past practices in Investment Analysis [Wall Street]. Had there been any general agreement among analysts themselves concerning the proper criteria of value, such enormous fluctuations should not have occurred, because the long-run prospects for dividends have not, in fact, changed as much as prices have. Prices have been based too much on current earning power, too little on long-run dividend-paying power. Is not one cause of the past volatility of stocks a lack of a sound Theory of Investment Value? Since this volatility of stocks helps in turn to make the business cycle itself more severe, may not advances in Investment Analysis prove a real help in reducing the damage done by the cycle?” 

Gradually, particularly among seasoned investment analysts and some academicians, Williams’ valuation theories gained credence. Arnold Bernhard, the founder of “The Value-Line Investment Survey,” perhaps the most famous of all independent, investment research firms, quoted Williams in his book, The Evaluation of Common Stocks, and echoed his concerns, 

“Williams postulates that the value of a stock is the sum of all its future dividends discounted by the present interest rates. . . . Because there is no generally accepted standard of value, the market prices of stocks fluctuate far more widely than their true values. The wide fluctuations have in the past imposed a heavy burden on the general economy and undermined the faith of many people in the free market economy. The need, therefore, exists for rational and disciplined standards of value that cannot lead to the wildness of 1929 or 1949 or the present." 

Myron Gordon in his 1959 book, Dividends, Earnings, and Stocks Prices, pays tribute to Mr. Williams for his pioneering work in discovering methods of calculating the intrinsic value using the dividend.  Mr. Gordon would later win a Nobel Prize for his expansion of John Burr Williams' ground breaking work.  There are many academics, as well as, investment professionals who believe that Mr. Williams' work also deserved a Nobel prize.

John Burr Williams is called the "father of dividend investing," but he was much more than that.  Williams recognized that the erratic behavior of stock prices was caused by a lack of connection to the true, fundamental value.  He was one of the first people to quantify the intrinsic value of a company.    

John Burr Williams' theories are the foundation upon which we have built our Rising Dividend Investing strategy.  Over the last 20 years of employing his ideas, we have seen time and again that prices for individual stocks and the market as a whole are often disconnected from what is later shown to be their true intrinsic value.  

Next time, we will discuss Williams' views on investing versus speculating.  

John Burr Williams: Investing Versus Speculating

John Burr Williams believed that the stock market was far more volatile than the long-run dividend paying abilities of the underlying companies would justify. This fixation with the short-term, led to periods of gross over and undervaluation in stocks, which, in turn, led to booms and busts in the economy. Williams believed that the cycle of booms and busts caused many people to lose faith in the free market economy and the markets, which ultimately led to the socialist-like economic policies of the 1930s. His book was not about beating the market, or getting rich in the market, it was really a wake-up call to the investment elite of his time to offer them a theory of investment value that would encourage more long-term investing and less speculation. Williams realized that speculators would always be with us, and were a legitimate enterprise, but he wanted to provide tools for investors to aid them in making decisions based on the “investment value” of a company, not just its price momentum. Williams postulated that investors’ inability to properly value stocks, increasingly, led them to become speculators. Most people would not admit that they were speculators, but when they were asked to explain their buy and sell decisions, it was clear that they were not appraising the intrinsic value of companies, but betting that they knew something that the market did not. In one of Williams’s most insightful observations, he makes the following statement: “To gain by speculation, a speculator must be able to foresee price changes. Since price changes coincide with changes of marginal opinion, he must, in the last analysis, be able to foresee changes in opinion. Successful speculation consists in just this. It requires no knowledge of intrinsic value as such, but only what people are going to believe intrinsic value to be. . . . Hence, some old traders think it is a handicap, a real handicap, to let themselves reach any conclusion whatsoever as to the true worth of the stocks they speculate in. How to foretell changes in opinion is the heart of the problem of speculation, just as how to foretell changes in dividend is the heart of the problem of investment. Since opinion is made by the news, the task of forecasting opinion resolves itself into the task of forecasting the news. There are two ways to do this: either cheat in the matter, or study the forces at work. Cheating has been outlawed, so far as can be, by the Security Act of 1934. The other way to forecast the news, and thus the change of opinion and the movement of prices, is to study the forces at work, in the belief that ‘’coming events cast their shadows before.’ But, rare is the man so sagacious as to foresee, so certain as to believe, and so steadfast as to remember; he who is makes a good speculator. Every speculator’s life is strewn with regrets, vain regrets for the news that he did not understand until it was too late. That ‘time and tide wait for no man’ he knows full well; like a bird on the wing must be shot in a jiffy, or she flies out of range forever. Hence, the first speculative opinions are usually wide of the mark, and as such, they usually need to be revised by the later trading of those who have had time for a sober second thought.” John Burr Williams was not condemning the speculators, but he was trying to open the eyes of investors to the fact that, as Ben Graham said, “In the short run the market is a voting machine (popularity contest), while in the long run it is a weighing machine (measure of value).” This is the sum total, essence, bottom line, and raison d'etre of Donaldson Capital Management. Long-term values of companies are determinined by what you can get out of them. That is why we scrutinize dividend levels and dividend growth. This is where value is created. This is where value can be measured. Finally, this is where we can find opportunties. Opportunities that are being shunned because today's news is not positive or is murky, but opportunities that have already discounted all the bad news and now stand ready to rise, driven by the intrinsic value of the company. Amen

John Burr Williams and the Theory of Investment Value, Part 2

Mr. Bernhard was echoing Williams in pointing out the need for generally accepted criteria to value stocks. He also joined Williams in warning that the effect of not having such criteria resulted in excess stock market and economic volatility, which damaged investor confidence not only in the stock market but also in the free markets. Bernhard then boldly states, “In our own experience, during periods of inflation as well as at other times, in this country and abroad, it has been found that dividend-paying ability is the final determinant of the price of a common stock. Whenever, over a period of years, the dividend, or the ability to pay dividends, went up, so too did the price of the stock. When the dividend-paying ability went down, so did the price of the stock, inflation or no inflation.” In applauding Williams’s theory, however, Bernhard inserted a subtle twist to Williams’s basic premise by adding the words, “the dividend, or the ability to pay dividends.” By adding just these few words, he reentered the world of earnings and left behind the “dividends only” world that Williams had described as so important in determining long-term intrinsic value. Warren Buffett, Chairman of Berkshire Hathaway and the most famous investor of modern times, makes a similar twist. He is famous for saying that investing is easy: “just buy wonderful companies at good to great prices.” When asked to explain what good to great prices means, he credits John Burr Williams’s formula for intrinsic value, but defines it with a different twist: “The value of any stock, bond, or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset.” Warren Buffett substitutes cash flow for dividends and Arnold Bernhard substitutes earnings. Neither Buffett nor Bernhard nor many of the thousands of others who have quoted John Burr Williams over the years is saying the same thing Williams said. Williams was speaking of dividends alone, not earnings, cash flow, or a combination of the two. Williams went so far to keep dividends at the center of his methodology that he included in his thesis a section titled “A Chapter for Skeptics.” There he explained that he was certainly aware that without earnings and cash flow there would be no dividends, but he steadfastly asserted that they mattered only if you owned the whole company..” Indeed, in what must be one of the most amazing paragraphs in the history of doctoral dissertations, he offered the following: “Earnings are a means to an end, and the means should not be mistaken for the ends. In short, a stock is worth only what you can get out of it.” [Italics are the author’s.] He then added the following poem: “ Even so, the old farmer said to his son: A cow for her milk, A hen for her eggs, And a stock, by heck, For its dividends. An orchard for fruit Bees for their honey, And stocks, besides, For their dividends. The old man knew where milk and honey came from, but he made no such mistake as to tell his son to buy a cow for her cud or bees for their buzz.” In saying dividends, not earnings, were the determining factor in calculating intrinsic value, Williams knew he was reversing the normal rule that every investor learns when they start investing in the markets. Williams answered this issue with the following statement, “The apparent contradiction is easily answered, however, for we are discussing permanent investment, and not speculative trading, and dividends for years to come, not income for the moment only.” John Burr Williams struck a bright line between being in the chicken business and being in the egg business. He believed, as we will see later, that buying and selling chickens had no predictor and thus was pure speculation. On the other hand, investing in egg-laying chickens was completely different. It was possible to calculate the present value of a chicken by estimating its total egg-laying potential during its lifetime and then discounting it to a present value.

John Burr Williams and the Theory of Investment Value

Because we have long espoused John Burr Williams' theories of dividend investing, we are often asked why he focused on dividends and not on earnings in determining a stock's value.  This prioritizing of dividends ahead of earnings was controversial in 1937 when he published his book, and it remains so today.  

This is Part 1 of series of three blogs in which we will describe who John Burr Williams was, why he believed dividends trumped earnings in determining the intrinsic value of a company, and finally, why his theories matter so much today.

In 1937 near the end of the worst bear market in US history, Williams, a thirty-five year old Harvard doctoral student in economics, made the following statement in his thesis: “The investment value of a stock is the present worth of all future dividends to be paid upon it . . . discounted at the pure [riskless] interest rate demanded by the investor.” 

Mr. Williams’ dissertation, entitled “The Theory of Investment Value,” did not immediately earn him his doctorate. That would not be forthcoming until 1940.  Prior to his final oral exam, he sold the rights to his thesis to Harvard University Press, who published his dissertation as a book, but only with Mr. Williams subsidizing a portion of the costs. 

It would seem that only foolish greed could compel a doctoral student to sell his thesis before he had been granted the degree. Williams, however, who was already a successful Wall Street investor when he went back to Harvard, explained that he had returned to college to learn what had caused the 1930s stock market crash (and the subsequent economic depression) from the best minds possible. Since he had come for the knowledge and not the degree and since his work was complete, he wanted to share his findings with the public as quickly as possible. 

What he did not say at the time, but would later admit, was that because of some of the views he had expressed in his thesis, he had become persona non-grata with key Harvard professors and was unlikely to have been awarded the degree anyway. 

Blaming the Bureaucrats 

His troubles with the dons of the school of economics were many but were centered in two areas: (1) Williams claimed that the correct method of determining the intrinsic value of a company was by calculating the present value of its future dividend payments, not earnings as was the universal belief at the time, and (2) he voiced great skepticism of the theories of John Maynard Keynes and the state-sponsored programs of President Franklin Roosevelt. Williams devotes an entire chapter in the book entitled "Taxes and Socialism" to debunking the notion that the redistribution of wealth could lead a country to prosperity.

Finally, in 1940, with the book drawing praise from important financial commentators, and his success as an investor gaining accolades, John Burr Williams went before the Harvard dons to seek his doctorate. 

As expected, he was soundly criticized for publishing the thesis before he had obtained his doctorate, and his professors were upset that he did not embrace Keynes’s teachings. Oddly enough, however, they did not dispute his dividend-centric theory of investment value but questioned if a thesis studying the valuation of stocks was of enough significance to justify a doctorate in economics from Harvard.  After a heated debate he was granted his doctorate. 

The truth is often born of travail, matures under constant testing, and once acknowledged, is subject to twisting. That has certainly been the case with John Burr Williams’ theory. What had angered his Harvard professors, at first, caused Wall Street brokers to scoff. The majority of the wizards of Wall Street believed then, as they still do today, that earnings are the driver of stock prices and that dividends are only a by-product. Furthermore, intrinsic value has never commanded a big following on Wall Street, where trading and short-term speculation have long been the accepted modus operandis. 

Blaming Wall Street 

But, a closer reading of the book turned Wall Street’s ridicule to scorn. The ways of Wall Street were being blamed, at least partly, for the stock market crash. Williams' thesis stated the following: 
“The wide changes in stock prices during the last eight years, when prices fell by 80% to 90% from their 1929 peaks only to recover much of their decline later, are a serious indictment of past practices in Investment Analysis [Wall Street]. Had there been any general agreement among analysts themselves concerning the proper criteria of value, such enormous fluctuations should not have occurred, because the long-run prospects for dividends have not, in fact, changed as much as prices have. Prices have been based too much on current earning power, too little on long-run dividend-paying power. Is not one cause of the past volatility of stocks a lack of a sound Theory of Investment Value? Since this volatility of stocks helps in turn to make the business cycle itself more severe, may not advances in Investment Analysis prove a real help in reducing the damage done by the cycle?” 

Gradually, particularly among seasoned investment analysts and some academicians, Williams’ valuation theories gained credence. Arnold Bernhard, the founder of “The Value-Line Investment Survey,” perhaps the most famous of all independent, investment research firms, quoted Williams in his 1959 book, The Evaluation of Common Stocks, and echoed his concerns, “Williams postulates that the value of a stock is the sum of all its future dividends discounted by the present interest rates. . . . Because there is no generally accepted standard of value, the market prices of stocks fluctuate far more widely than their true values. The wide fluctuations have in the past imposed a heavy burden on the general economy and undermined the faith of many people in the free market economy. The need, therefore, exists for rational and disciplined standards of value that cannot lead to the wildness of 1929 or 1949 or the present." 

 Next Time: Investing versus Speculating