Dividends, Lies and the Tape: Whither Earnings Trends?
According to widely-received market theory, stock market trends over time are highly co-related to corporate earnings. While that is certainly true over the longterm (everything else being equal) the relationship is quite variable over the shorter-term. In fact, here there is probably no correlation at all. Yet, surely, booming corporate profits over the past half decade have been a key underpinning to equity market gains. And, if earnings are a key bellwether for longer-term market trends, whither earnings trends?
Actually, any analysis of earnings must give consideration to two factors that do not lend themselves easily to either forecasts or measurement -- future expectations vs. reality and cyclicality. While there are no lack of analysts who argue that the business cycle is dead , a quick glance at the graphs on this page will quickly dispel that notion. Competition and self-interest are inherent in the capitalistic system. As such, no matter the state of advances in economic and monetary fine-tuning, cyclicality of some form will remain a feature of financial markets. After all, the (US) corporate profits cycle is presently at the highest in at least 50 years measured as a percent of National Income (NI, 14.4% , 3rd quarter of 2006).
An insightful approach to addressing this crucial trend is the dividend trend.
Dividends Don't Lie. One of the key attractions of studying dividend payment trends is the straight, hard fact that they don't lie. As they are mostly paid in cash (in recent years, increasingly in the form of stock dividends and stock buybacks) what you see is what you get. They're not subject to revision and adjustments -- whether seasonal, hedonic, or inflation-related. And, because of this verifiable nature, dividends have reliable predictive qualities. Managements' decisions with respect to dividends can provide an insight into expected profit trends.
We have commented on this phenomena in years past, first publishing this model in the 1980s. (See The Global Spin of February 17, 2003 for a more recent in-depth review). It depends upon one main presumption -- that management loathes cutting dividends. To do so is perceived as a negative event, perhaps triggering a severe decline in the share price. Therefore, companies only tend to raise dividends when they are reasonably sure of a sustainable earnings base. In this way, they seek to avoid the embarrassment of a dividend cut even in a cyclical downturn. It's this vested behavior that can signal "insider" profit expectations. There is no reason to believe that this behavior has changed. If anything, in this day of the mighty executive stock option (back-dated or not) it will be reinforced.
Whenever dividend increases start to trail earnings improvements, it implies that management does not regard current earnings levels as sustainable enough to ensure a permanent dividend increase. In environments like this, then, the dividend payout ratio declines. Anytime this has happened over the past half century, and earnings momentum (we prefer 2-year momentum) has decisively peaked, earnings have usually fallen to a level compatible to dividend levels within two years. We say usually. This model gave a false "topping signal" in early 2005, only to give way to almost two more years of robust earnings growth. Extraordinary monetary and geopolitical events intervened.
Recently, another trend-change has been signaled. Will it be correct this time? Time will tell. Yet, clearly earnings momentum has peaked, whether viewed on a year-over-year basis or over 2- or 3-year momentum periods.
Figures# 1 and #2 show this to be the case.
What makes this signal now all the more momentous, is that US corporate earnings are at a record high relative to cyclicallyadjusted levels. As the saying goes, the bigger they are, the bigger the (potential) fall.
That said, we must make one admission. The dividend payment is no longer the "honest tattler" it used to be. Over the recent decade, dividend policy has increasingly become a tool to float equity markets, rather than a means to return income to shareholders. This happened as the culture of the "executive share option" began to build as of the early 1980s, and then really took off in the early 1990s along with the EVA ("economic-valueadded") theory and other such similar ideas. The dividend payment gradually took on a new purpose. As such, the time-worn verities embedded in the dividend payment have since become somewhat more opaque.
Yet, despite the recent bias to use dividends to prop up equity prices, we have other reasons that add weight to the expectation of an impending profit peak ... and, yes, even a decline, though that notion will seem thoroughly unimaginable in the current halcyon environment.
The Causes of the Corporate Profit Boom. Traditional theory holds that investment spending is one of the primary propellants of profit growth. It is only logical that this is the case. Capital spending has current effects on incomes while the associated expense of depreciation against revenues is deferred into the future in large part. The remarkable thing is that the corporate earnings boom of the past half-decade was not driven by a strong capital spending cycle. Far from it. Yet, even so, corporate investment spending is now expected to decelerate though profit margins are currently high. US surveys show this to be the case. In Canada, a recent Statscan report predicts investment spending to decelerate to a growth rate of 4.6% this year, compared with 8.8% in 2006. All in all, this is another reason that corporate earnings growth will show a downshift in the near future.
Then what drove up corporate earnings so sharply in recent years? Besides the usual drivers -- declining interest rates and reasonably vibrant economic growth -- could it have been foreign or perhaps ballooning financial earnings?
Surprisingly, it was not foreign earnings. It would have seemed intuitive that this should be so, given the slumping US dollar and the large number of US multinational corporations with significant overseas operations. Actually, foreign earnings have only risen a faint 0.4% of NI (from 1.6% at the earnings nadir of the third quarter of 2001 to 2.0% five years later.) We don't know what to make of these statistics other than that this earnings source is probably the most managed of all.
We're reminded of a quote out of Raymond Baker's recent book, the Achilles Heel of Capitalism: "According to various estimates, half of cross-border trade and investment passes through a tax haven or a secrecy jurisdiction at some point along the way." He identifies "63 jurisdictions providing varying degrees of incorporation concealment and protection from probing eyes."
Then, what about financial earnings? Surely, an ongoing financial bubble has driven these to all-time highs. Yes, but not as much as may be thought. The rising share of financial sector earnings in the US assuredly has been a long-running trend. (See The Global Spin, The "End of Financialization" ... Maybe? of August 15, 2005 for an in-depth analysis of this phenomenon.) However, while financial earnings have continued to enlarge as a share of National Income (hitting a level of 4.4% in the second quarter of 2006) it is non-financial earnings that has really boomed.
Domestic non-financial earnings bottomed at a level of 2.3% of NI in the 4th quarter of 2001. By the 3rd quarter of 2006, this source of earnings had zoomed to 9.5% of National Income .... up by over 4 times in relative terms. This is the highest level since early 1967 but below the all-time peak of 11.5% in the 1950s.
We see that there have been really two trends unfolding on the domestic profits scene in recent years. 1. The continued secular rise in financial profits to successive new record highs, and 2. A cyclical boom in domestic non-financial profits during the past five years. Together, they have contributed to an all-time high in profit intensity. In other words, the record earnings boom couldn't have happened without a financial boom. But, of course, this does not adequately explain why domestic profits quadrupled.
Certain other secular and geopolitical factors also appear to have intervened to contribute to this result over the past five years. In our view, it is directly related to at least three unusual factors. 1. A domestic housing-related consumption boom. 2. A foreign outsourcing surge which has served to lower costs of goods. The reciprocal witness of this development being seen in the abnormally low job and income growth statistics over this same period. And, 3. The interweaving effects of an ongoing financial bubble and debt-induced consumption. All three have worked together to drive the overall earnings boom to all-time highs (measured as a share of national income.)
Conclusions. Several conclusions unfold from our brief analysis, impinging upon both cyclical and secular trends. Firstly to the cyclical: The business cycle is likely to continue. It may have been altered due to the changes in inventory management -- historically, one of the largest contributors to cyclical variations in economic growth in the post-World War II period -- but it remains. Consider that earnings here are at all-time highs, having resoundingly bucked a declining trend that has lasted more than four decades. And now, our dividend model has signaled an earnings trend change.
Financial sector earnings logged their first decline in relative terms during the 3rd quarter of 2006. Given recent tremors in subprime debt markets and beginning loan write-downs, might the 3rd quarter prove to be a bellwether of a much longer-running trend? Figure #3 shows the sharp divergence in the trend of financial share prices and credit conditions. We also do not want to forget that the housing boom has indeed come to an end and with it a sharp decline in mortgage equity withdrawal (MEW). There can be little doubt that this source of consumer spending power was not an inconsequential driver to domestic profit growth over the past five years. And what about the continuing benefit of foreign outsourcing? That's a tough call ... the realm of geopolitics, currencies and non-price sensitive foreign central banks. Things will continue here as they are for a while longer ... or they won't.
All in all, the impact of slowing earnings (or indeed even falling earnings) upon equity markets is understood easily enough. However, we also conclude that it is time to shift away from corporate bonds and back to sovereign bond issues. Given the likelihood of slowing earnings growth as well as the prospect of a widening deterioration in overall credit quality -- ample evidence of this in the past months -- low yields spreads no longer provide sufficient comfort. The ticker tape in recent weeks could very well be foreshadowing a future re-evaluation of overall risk levels. Recently, yield spreads have begun to widen.
Dividends don't lie and the tape is beginning to tell a new story.