David Rosenberg: Stock prices haven’t been this disconnected from the fundamentals since the dotcom bubble

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A key theme we continue to revisit is that equities are getting ahead of themselves — in terms of current vs. intrinsic value — leading to a poor outlook when it comes to forward returns.

Indeed, this is the primary reason our model has been cautious since our Strategizer publication was launched in December. There are numerous ways to gauge fair value, but perhaps the simplest is the Gordon Growth Model, which relies on the income an investor receives (and the growth of said income stream) to derive return expectations.

Traditionally, this model has used dividend payments as the sole input, but given the rise of share buybacks since the 1980s as an alternative form of capital distribution, we opted to include both in our analysis as a “total payout” to investors. We also decided to use net buybacks, as opposed to just gross, to account for the fact that any issuance of equity acts as an offset that should not be ignored by shareholders.

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Looking at the accompanying table, we can see the results by decade and can compare actual equity returns to what was expected given the yield (we used the median during each period) and the annualized growth rate of total payouts to shareholders. Also, to clarify, the table was derived using the Federal Reserve’s Flow of Funds data, given its broad nature and longer available history when it comes to net buybacks.

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Perhaps unsurprisingly, U.S. equities during the past decade appreciated at a significantly faster rate than what would have been expected based purely on fundamentals — with an actual total return of 13.9 per cent annualized, compared to the anticipated 6.9 per cent gain. This delta (between actual and expected returns) puts the last 10-year period just shy of what the market experienced in the dotcom bubble, where stocks returned 17.5 per cent annualized vs. 9.9 per cent expected. To us, this confirms the frothiness we have witnessed in the market, as sentiment, momentum and liquidity have accounted for significant excess return.

To be fair, the table is a backward-looking analysis of gains after the fact, but the same formula of yield and growth can be used to get a sense of future returns as well. In this regard, it should be noted that the current total payout yield of 1.4 per cent is among the lowest values on record, meaning that equities are starting this decade with a 96th percentile reading by this valuation metric — expensive to say the least. To get back to its long-term median of 2.4 per cent, either stock prices will have to go down (the denominator in the formula) or appreciate at a slower pace than total payout growth (the numerator). Neither of these scenarios point to future outsized gains.

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The bigger picture brings us back to our belief that the unrelenting surge in stocks following the COVID-19 crash has merely been an extension of the prior bull market and that the exceptionally strong gains we have seen are just robbing from future returns.

From our standpoint, we did not experience the prolonged shakeout that is typically required to reset the equity market. As such, until prices adjust (either through a correction or by simply treading water) to better align with fundamentals, we believe forward return expectations (for equities as a whole) should be adjusted downward accordingly.

Join me on Webcast with Dave on June 15, when I will be hosting Lacy Hunt, executive vice-president of Hoisington Investment Management‎. Learn more on mywebsite.

A free offer to FP readers: If you like this insight from Rosenberg Research’s Strategizer report and haven’t subscribed to our FP Investor newsletter yet, you should, because the next issue will include a link to get the full Strategizer client report for free.

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