The S&P 500: No Bargain For Income Investors

Includes: SPY
by: Colin Reed

Rebounding from 2008/09, S&P 500 corporations recorded the biggest increase in profitability since 1900. The 12-month EPS for the index is $94.77, surpassing the peak of $91.47 set in 2007. Analysts estimate earnings will reach $104.78 in 2012. Despite record profitability, large established US corporations with long histories of profitability are choosing to retain large portions of their earnings. This is no recent phenomenon.

From 1982 - 2011 the S&P 500 payout ratio fell from 50 to 30%. As of Q3 2011 it stood at 28%.

From 1982 - 2011 average yield on the S&P 500 fell from 5.5 to 2%. As I wrote this, it was 1.92%.

Compare this to other markets:



ASX 2011 Payout ratio = 70%

FTSE-100 2011 Payout ratio = 50%

ASX 2011 Average Yield = 4%

FTSE-100 2011 Average Yield = 3.85%

Most other major European markets are in line or exceed UK levels. Out of all the developed markets outside the US, currently only Japan's yields are lower.

The speed and strength of the return to profitability for S&P 500 companies has not changed their payout structure. Had S&P ratios been closer to other developed markets prior to '08, the current low payout ratios might be justifiable on the grounds of balance sheet rebuilding. The problem is not with the balance sheet. US corporations are holding record amounts of cash. As of Q4 2011, non-financial companies in the S&P 500 held in excess of $1.1 trillion. Cash holdings make up 7.1 percent of all company assets, the highest level since 1963. The problem is off the balance sheet. It is structural, and it appears to be permanent.

I believe the underlying cause is twofold. On the one hand we have an ingrained management culture focused on reinvesting or retaining profits, rather than returning cash to shareholders. On the other, a shareholder culture which increasingly focuses on stock's short term price movement. If we strip High Frequency (HF) from the data, and measure average holding periods for NYSE stocks between 1940-1975, they remained steady at around 7 years.

By 2007, (before HF impacted) it had fallen to 7 months. The data would strongly suggest that the motivation for owning equities has changed. Instead of a buy and hold strategy to capture a growing dividend, stock buyers seem primarily focused on short term capital gains. Short holding periods make dividends less important to total return, thereby taking pressure off management to increase payouts to stockholders.

The so called 'valuation slump' currently prices the S&P 500 at 13.7 times earnings - well below its 16.4 long term average. While it may be compelling for value investors, it is no bargain for income investors. After 10 quarters of U.S. economic growth, they are still not seeing much cash.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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