Short of a market meltdown on the last trading day of the first quarter, the Dow 30, S&P 500 and NASDAQ Composite are poised to deliver price-only returns of 6.50%, 5.50% and 4.50% respectively. By most measures these are impressive returns given the economic and geopolitical events since the calendar turned to 2011.
With the Dow 30 registering the largest gain of the major indexes, we would suggest that the market is becoming more discerning in stock selection, favoring high-quality companies with strong balance sheets, dividend growth, and earnings stability. This is in stark contrast to the pursuit of lower-quality issues that were favored in the aftermath of the March ’09 market lows.
Some among the punditry suggest this is a common occurrence when a market advance matures; others suggest this is the market anticipating that the easy-money days are ending or about to come to an end. In any event, the quality and value sector of the market is benefiting, so far be it for me to quibble about the reason(s) why.
I have long espoused that the markets really fear only two things; recessions and rapidly increasing interest rates. Why is this? While complex on the surface, the fact of the matter is that over the long-term, the markets are basically driven by two primary factors: earnings growth and the inflation rate.
Two criterions that value investors look for are growth of earnings and growth of dividends. Dividends are only possible as a result of earnings so logically, increasing dividends are only possible from a trend of increasing earnings. One of the tenets of the Dividend-Yield Strategy is that a rising trend of dividends is a predictor of rising stock prices. When a company consistently increases its dividend payout to the shareholder, the stock price must eventually rise to reflect the increased value to the shareholder.
The sustainability of earnings growth, however, is dependent on the economy. Trees do not grow to the sky; neither do economies. After a long period of expansion, economies inevitably develop excesses that must be worked off, meaning there must be a period of contraction, which we know more commonly as a recession. Typically during a recession we see a decline in earnings growth which can impact dividends and therefore stock prices.
The inflation rate is the second factor that drives the markets. In a period of rising inflation, interest rates tend to trend higher. In a period of low to stable inflation, interest rates tend to trend lower. All things being equal, the market prefers low to stable inflation rates because a low interest rate environment is more conducive to the earnings growth that leads to increased dividends and higher stock prices.
Unfortunately, there are no crystal balls that can tell us what the future holds for earnings growth and the inflation rate. Due to this uncertainty many investors, particularly the large institutions, try to anticipate the potential market environments and develop strategies to position their portfolios for the best possible outcome. In the industry this exercise is called forecasting. For all intents and purposes however, it is nothing more than a sophisticated form of speculation.
This is not to discount the ability of mathematical models to project the potential rates of return for the major market indexes given a range of economic growth and inflation rates. Quantitative analysts have constructed equations that use these variables to solve for the outcome of X growth and Y inflation equals Z return.
For those that follow this approach, the trick is to pick the right scenario. If one has to choose between, say, four or five different scenarios, the odds are one in four or one in five you will be right. The flip side is in three of four or in four of five you will be wrong.
With the above as a backdrop, it is easy to see why investors often struggle to make sense of a market that is often hard to understand; not to mention knowing what to buy, when to hold and when to sell.
In closing, investing on projections and news is a difficult row to hoe. This is why value investors are attracted to the elegant simplicity of following the dividend-yield extremes of high-quality companies that have long track records of managerial excellence, sustained earnings growth and rising dividend trends. While all stock prices fluctuate, sometimes for extended periods, the shares of these companies tend to reward investors who are patient with long-term capital growth and increasing income streams.
It isn’t a crystal ball but it passes the pillow test. For the enlightened investor, a good night’s sleep is hard to beat.
