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Written by: Jacob Johnston | Advisor Asset Management
After two-plus years warning of the consequences of unanchored inflation, Chair Powell delivered a rather significant pivot late last year by signaling the end of the tightening cycle and left the door open to multiple rate cuts in 2024. Risk assets, including the equity markets, delivered a rather significant reaction to the change in tone. The S&P 500 rallied over 11% in the fourth quarter alone and ended the year with a gain of 26%, just shy of an all-time high. Furthermore, equity returns in the fourth quarter were (finally) broad based with solid breadth and participation. These strong underlying trends suggest the momentum could continue, but with valuations stretched we expect returns to be a little harder to come by and potentially derived from a different source. We offer three timely sources of yield potential to enhance equity returns as we enter a new year and possibly a new phase.
Valuations
Despite the strong returns, earnings per share (EPS) for the S&P 500 ended 2023 almost exactly where they started, meaning the 26% gain was entirely produced by multiple expansion. According to FactSet, the S&P 500 forward 12-month price-to-earnings ratio (P/E ratio) is 19.5. This is above the 5-year average of 18.9 and above the 10-year average of 17.6.
Past performance is not indicative of future results.
It is important to note EPS is estimated to grow approximately 11% over the next 12 months. Even with double-digit growth estimates, forward P/E ratios are well above long-term averages.
The historical relationship between P/E ratios and subsequent equity returns shows higher valuations tend to produce lower forward returns. We find further multiple expansion to be unlikely and with the expectation of lower forward returns from these levels, we believe it is an opportune time to consider additional sources of yield.
1. Dividend Yield
There were segments of the market that did not participate in the 2023 rally that are not burdened by stretched valuations. For example, the S&P 500 Dividend Aristocrats underperformed the S&P by 17%, the worst relative year since 1999. The S&P Dividend Aristocrats Index P/E ratio is 17.5, below both it’s 5-year and 10-year average, and a 10% discount to the S&P 500.
2023 followed a similar trend this decade in which price change has been the main component of total return. Since 2020, the S&P has returned 57.6%. The dividend percentage of total return has been just 17%, the lowest contribution by decade and far below the long-term average of 59%.
Source: Strategas | Past performance is not indicative of future results.
Dividend yield looks attractive based on current valuations and the potential for mean reversion where the dividend contribution plays a larger role in total returns going forward.
2. Option Yield
Derivative income investments, such as covered call strategies, have the potential to capitalize on lower return environments by selling away upside potential in exchange for premium income. The premium income — or “option yield” — can supplement total return in gently rising markets or provide a potential cushion in down markets.
Source: Advisors Asset Management | For illustrative purposes only.
Due to recently volatility (both up and down), covered call strategies currently offer competitive yields relative to historical averages. After the strong run-up in equity prices in 2023, the benefits of incremental income have the potential to outweigh the cost of capped upside potential, in our opinion.
3. Buyback Yield
The possibility of rates coming down provides incentive for companies to deploy capital. Share repurchases have increased significantly in recent years, including a notable spike to start the year in January. In fact, S&P 500 companies have spent more money on stock buybacks than dividend payments in each of the last five years, generating a higher “buyback yield” than dividend yield, when measured against the market value at the beginning of the period.
Source: S&P Dow Jones Indices. As of 9/30/23 | Past performance is not indicative of future results.
Historical returns data from Ned Davis Research suggests companies with a consistent focus on returning capital to shareholders via repurchases have rewarded investors with above-average returns. Strategies focused on buybacks have the potential to complement existing dividend-oriented positions and may provide another powerful source of shareholder return.
The banner year for stocks in 2023 reminds us that the equity markets are quite unpredictable. However, in our opinion, diversified yield from dividends, covered calls, and buybacks are a few examples of fundamentally sound ways to potentially generate more predictable sources of return for portfolios that are not dependent on a Fed pivot or multiple expansion and could be well positioned for the year ahead.
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