Investors have many reasons to doubt Wall Street's high-flying stocks, but the best reason of all may come as a surprise: This market is simply too generous for its own good.
Aswath Damodaran, a professor of finance at New York University and widely followed expert on corporate valuation, says the Achilles heel of the Standard & Poor's 500 is management's habit of paying out more to shareholders than companies are generating in profits. Part of this payout comes in the form of lush dividends. Another big dollop comes in the form of share buybacks, in which companies purchase their own stock as a way of goosing the price.
This excessive generosity cannot continue indefinitely. At some point, payouts have to come back into alignment with profits. "Put bluntly, U.S. companies cannot keep returning cash at the rate at which they are today," Prof. Damodaran wrote in a recent blog post.
By his calculation, in the 12 months up until August, U.S. companies poured 112% of their earnings back into shareholders' pockets through dividends and buybacks. That continues a trend that was established in 2015, when companies returned almost 106% of their earnings.
If you're a worrywart like me, you can't help but notice that the last time the market hit insanely generous levels was in 2007 and 2008, just before the financial crisis (see chart at bottom). But back then, there were understandable reasons why businesses paid out more than they earned. Profits then plummeted, and the worst economic shock in decades shook the world. Managers had to reel back payouts to levels lower than shrunken earnings.
It's much harder to understand the current outburst of generosity. Yes, earnings surged after the financial crisis, and while they've weakened over the past couple of years, they remain at historically elevated levels as a percentage of the economy. For some reason, though, companies are going beyond even those expansive limits to reward investors with more, more, more in the way of dividends and buybacks.
One likely motivation for this generosity is management incentives. Top executives get rewarded for creating shareholder value, so they have strong, selfish reasons to use any means necessary to keep share prices aloft.
The problem, of course, is what happens next. Earnings will inevitably hit a serious bump at some point. Many investors may then be surprised to discover how little undergirds today's stock prices. What is the difference between a classic Ponzi scheme and today's strategy of rewarding investors with unrealistic payoffs? Um, don't ask.
I kid, of course. These are the greatest companies in America we're talking about, so by definition whatever they're doing must be beyond reproach. To suggest otherwise would be to believe in an absurd universe where big banks like Wells Fargo could prey on their own customers, and market darlings like Valeant could massage reality by developing exotic accounting treatments to make their results look better.
Come to think of it, maybe we shouldn't pursue this line of argument. So, back to earnings.
Companies typically pay out less to shareholders than they earn because businesses need funds to invest in new projects that can help grow future earnings. One defence of today's corporate generosity is that managers simply don't see promising ways to deploy their cash in the current economy. If so, CEOs are doing the right thing by returning excess capital to their investors.
Unfortunately, this explanation doesn't match the optimistic rhetoric of companies themselves. If investment opportunities are bleak, shouldn't managers be scaring us with predictions of stagnant earnings ahead? And why would they pay out everything they earn at the same time as they are bracing for tougher times?
The ideal way for the current mismatch between earnings and payouts to end would be for profits to surge. Sadly, analysts don't see such a surge coming any time soon.
So brace yourself for turbulence. One wise move, recommended by Prof. Damodaran, is to look beyond dividends and buybacks. Search for companies that have strong operating cash flows that can easily cover their payouts. So long as interest rates remain at rock-bottom levels, stocks are unlikely to crumble. Still, smart investors will use this time to build a cushion against the strong possibility that tomorrow's market will be substantially less generous than today's.
Ian McGugan