The Key Ingredient Needed For Future Returns

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Includes: DIA, QQQ, SPY
by: BlackRock

Rising price-to-earnings multiples and increasing payouts to shareholders - dividends and share buybacks - have fueled U.S. stock market returns since 2009. But in today's low-return environment, company earnings will be critical for generating gains.

My latest chart of the week helps explain why earnings growth is the key ingredient needed for future returns.

Click to enlarge

Companies have long been rewarded for returning capital to shareholders. Buybacks have shrunk share counts, contributing to rising multiples, while dividends have soared, with many companies using debt to fund payouts. Such strategies make sense in a low-yield environment, but the trend is unsustainable. The ratio of payouts in the form of buybacks and dividends to operating earnings of S&P 500 companies is now at 120 percent, as the chart above shows. Companies cannot continue to pay out more than they earn without increasing their corporate leverage.

Going forward, the market tailwinds from debt-fueled dividend growth and buybacks will fade, and we see limited scope for further increases in U.S. equity valuations. This implies lower equity returns, with the path of corporate earnings now key. For sustained earnings growth, companies need to increase capital expenditures at the expense of payouts.

So, will we see U.S. earnings growth in the near term? There are signs we could see positive U.S. earnings surprises later this year, driven by stabilizing oil prices and a halt in the U.S. dollar's rise. Also, the bar for upside surprises is unusually low given depressed earnings expectations. The potential for a U.S. earnings recovery later this year is one reason why we like U.S. stocks. For more on opportunities within the U.S. market, read my full weekly commentary.

This post originally appeared on the BlackRock Blog.