Profits Are At Record Levels And Stocks Are Cheap, But Boards’ Reluctance To Raise Dividends is a Concern
My first contribution to the end-of-year market outlook season is a big-picture view of the S&P 500 (in billions, and percent where applicable). The market capitalization of all 500 stocks still lags its 2007 level, but total revenues and profits hit all-time highs in 2011:
Those record profits have not induced firms to restore payouts to shareholders, however. Dividends and repurchases remain at their depressed levels from 2008-2009:
Aggregating across all firms, I created pseudo price/earnings, price/sales, and price/book ratios for the S&P 500. The slow mean reversion of US stocks’ relative valuation is evident in the graph below. The ratio of Market Cap/Net Income (or P/E) of the S&P 500 = 13.3, the lowest it has been in 20 years:
As shown in the next chart, stocks’ earnings yield is 7.5%, the highest in a generation. Firms’ dividend yield remains stuck at 2.1%, however, and the dividend plus repurchase yield is only 3.2%:
Stocks are gradually becoming cheaper. Investors have apparently remembered the long-forgotten concept of the risk premium. Cheap stocks beget bull markets (1982), but overpriced stocks beget wailing and gnashing of teeth (1999). Valuations are re-setting. The process takes an agonizingly long time, but it’s happening, and from the look of things, we’re almost there.
But cheap stocks are not enough to make a bull market; stocks need to be cheap relative to the underlying companies’ future prospects. And there’s one key signal that has yet to flash “go” for US equities: corporate boards have let dividend payouts lag far behind their historical relation with earnings. Below I’ve graphed the historical spread between stocks’ earnings yield and dividend yield. The 2011 spread of 5.4% is quite high by historical standards:
Of course, finance theory proposes that executives’ reluctance to increase payouts in proportion with earnings signals their lack of confidence that recent profit levels are permanently sustainable (Weigand and Baker, 2009 and Fargher and Weigand, 2009). Until firms raise dividends enough to increase yields, markets have no reason to believe that the incredible profit surge from 2010-2011 is the real deal. Instead of jawboning about business confidence, boards should simply pull the trigger and raise dividends decisively.
— Data from S&P’s Capital IQ
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Financial Market Commentary 
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