Two Disturbing Trends: Earnings and Dividends

by: Barry Ritholtz

Over the past few years, I have noted (repeatedly) that despite record earnings (Quarter after Q of double digit year-over-year gains), increasing dividends, M&A activity and rich share buybacks, stocks have been very range-bound. The analogy I favor is that each of those four items are an engine of a 4-engined plane. With all four spinning mightily, most indices are about where they were (give or take a percent) 2, 3, or 4 years ago. Only the Dow is above its 2,000 highs.

The danger of this four engined craft is that if any of the engines fail, the plane can be expected to lose altitude. Not crash into the mountains in a fiery conflagration, but seek a lower altitude before regaining stability.

The Earnings Question:

That process may be underway in the 3rd quarter. Despite the Dow reaching a record high (about 50 points from Dow 12,000 as I write this), both earnings and dividends are less robust than previous quarters. So far, we have seen increasing evidence that this Quarter's earnings -- as well as forward guidance -- are coming in softer than Q1 or 2.

The WSJ reported that:

"The strong forecasted earnings growth is perhaps the single most important piece of evidence pointing to a strong economy in 2007," wrote Dirk Van Dijk, head of research at Zacks, in a note earlier this week. The ratio, which has fallen below one -- that is, more companies issuing downward revisions, "is the canary in the coal mine, indicating that this pillar is perhaps not as strong as previously thought," Mr. Van Dijk said."

And, if Commodity & Energy prices remain depressed, the S&P500 will lose even more oomph. Those two sectors have accounted for a disproportionate share of the 14% year-over-year gains of the SPX in Q2.

The key question will be by how much. Psychologically, there is something significant about the y-y double digit gains. Let the SPX slide below 10% profit gains, and that will be a clear sign of decellerating economics -- and trouble.

So far, earnings have been mixed. After the Alcoa (NYSE:AA)/Genetech (Private:DNA)/Legg Mason (NYSE:LM) misses, there were strong numbers from Pepsi (NYSE:PEP) and Costco (NASDAQ:COST). But it has hardly been consistent, and the forward guidance is less than robust.

Consider this short list of headlines grabbed from The Thursday night; It certainly looks like more downside than upside to me:

How this plays out over the next few weeks may be a function of forces beyond fundamentals. I suspect the strength we have been seeing will attenuate as we get closer to the mid-term elections.


Dividends Begin to Slow:

As Barrons noted last week, for the first time since their resurgence in 2003, dividend increases declined in Q3: According to Standard & Poor's research of dividend data on 7,000 publicly traded companies, the number of payout boosts slid in three of the past four months. July and September suffered the heaviest declines. The drop was relatively small -- increases fell 3.6% compared to the year ago period.

Barron's quotes Howard Silverblatt, a senior index analyst at S&P:

"The quite disturbing, especially in light of the enormous expenditures on buybacks." Silverblatt thinks the major question is whether buybacks are increasing at the cost of dividend hikes. He noted that October is usually a busy month for payout enhancements and that the approaching earnings season "will be a critical time to evaluate" the slowdown in boosts. Unlike dividends, announced buybacks don't always materialize. (Even if they get started, they may not be completed.) In contrast, "dividend increases are a very big leap of faith that a company will have the cash flow to make the payments," Silverblatt asserted."

Consider the following data points regarding dividends:

• Companies in the S&P 500 are projected to spend ~$220 billion on dividends in 2006;
• That figure represents a 9% increase over 2005;
• Stock repurchases are up 12%, to $410 billion in 2006.
• For the first 3 Qs of 2006, dividend enrichments edged up 2.8% (compared with '05's initial 3Qs);
• Special (non-recurring) dividends advanced 19% in the 1st 9 months of the year, while reinstatements advanced 25%;
• S&P counted 14 dividend cuts last quarter -- 75% more than a year earlier. Omissions dropped 21%, while 29 companies decreased their payouts this year. The total of "passed payouts" was flat.

The action in the market at present is a function of liquidity and momentum - it is not fundamentally driven.

As noted above, I suspect it will continue until the election.