Recently we’ve witnessed what felt like a height of scientific achievement and a low point between SpaceX’s successful launch of Crew Dragon to the International Space Station and George Floyd’s heart-wrenching death followed by civil unrest. The world we live in is complex and at times confounding.
I will not attempt in this letter to predict how either of these events will affect financial markets. While their impact to our psyche and our state as a nation is important to acknowledge, the impact to the market (as with many other events) is impossible to forecast. I will, however, make the case for why a long-term investment in the stock market continues to make sense today.
Is the stock market divorced from reality?
When you turn on the news (if it is financial market news), you likely have come across skepticism about the recent stock market gains. And such predictions may seem fitting with some of the grim news around us.
But it is important to remember that the stock market is forward-looking, and it incorporates expectations for the future of what may happen in the economy even before economic data becomes available. What this means in periods of economic downturns and recessions is that the stock market generally recovers before positive economic data starts to come out.
We saw this happen during the 2008 financial crisis when the stock market recovered in March 2009, three months before the U.S. economic recession ended in June 2009. A lesser known fact is that it wasn’t until September 2010 (more than a year later) that it was officially declared that the U.S. came out of a recession in June 2009. The key take-away is that economic data tends to lag the stock market.
This is not just one isolated incident of stock markets returns preceding economic data. If we look at a given year’s GDP data versus the prior year’s stock market return, we see that there is a positive relationship between the two statistics. Meaning in years when GDP growth is high, the prior year’s stock market returns were high, and in years when GDP growth is low, the prior year’s stock market returns were low.
U.S. GDP growth versus prior-year stock premium
Past performance is not a guarantee of future results.
Source: Dimensional Fund Advisors1
None of this is to say that new information that impacts the economic outlook (e.g., negative news regarding a possible COVID-19 vaccine) doesn’t have the potential to derail the current stock market recovery.
Some market watchers even assert that current stock valuations are pricing in a best-case scenario of a recovery. Even if they are right, as an investor it is important to decouple short-term concerns regarding market movements from the long-term return potential for stocks.
Why stocks have a positive expected return … even today
A stock’s expected return comes from two sources: 1) future income and 2) future price appreciation (i.e., that someone in the future will be willing to pay more for the same stock than what it is worth today). We can debate whether investors will be willing to pay more for the same stocks in the future, but what is less controversial is whether companies will continue to generate profits in the future. Yes, those profits may be less than what they were expected to be pre-COVID-19, and there is still a great deal of uncertainty around how much profits may go down in the immediate term.
A rudimentary proxy for the income generated by stocks is the dividend yield. The S&P 500 dividend yield for the last 12 months is close to 2%. If we compare that to the 10-year treasury yield, which is currently 0.91%, based on yield alone, the case for stocks is compelling.
But what about companies cutting or suspending dividends as a result of the current environment? Per S&P Dow Jones Indices, so far in 2020, 40 S&P 500 companies have announced dividend suspensions, 18 have indicated they are cutting dividends and 11 companies have increased dividends. Compare this to the 2008/2009 recession, when there were 68 dividend cuts and 10 suspensions among S&P 500 companies.2
Does this mean an investor should focus only on dividend-paying stocks or stocks that pay the highest dividends? Not necessarily — we reference dividend yield to illustrate the continued return potential of stocks. Increasingly, companies return value to shareholders in the form of share buybacks, and data show that buybacks are an important contributor to stock returns.
S&P 500 dividends versus buybacks
Source: S&P Dow Jones Indices3
Another consideration for taxable investors when it comes to dividends are the tax implications. It is important to ensure that the holding period of the underlying stocks within a portfolio is managed to maximize the likelihood that dividends received are taxed at the favorable qualified dividend rate instead of the higher non-qualified dividend tax rate.
Wrapping it all up
The concerns about the ability of the stock market to sustain the recovery achieved since the recent March low are real near-term concerns. And while the market is unlikely to catapult into the stratosphere like Crew Dragon any time soon, we continue to have strong conviction in the long-term return potential of the stock market.
As your trusted advisor, we wish you and your loved ones both safety and peace of mind in these uncertain times. We are here for you and invite you to connect with us.