Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Buy fundamentals and sell sentiment as stimulus lifts dividend outlook
Peter Garnry
Chief Investment Strategist
Summary: Sentiment has improved dramatically over the past couple of weeks squeezing short positions creating what is most likely a technical bounce in the equity market. Dividend futures pricing expected dividends in 2021 have naturally improved by still suggest a 20% downside risk to S&P 500 from current levels. Our view is to buy fundamentals and sell sentiment which we explain how can be done.
In our latest equity note we suggested 37% downside risk to S&P 500 based on 2021 Dividend Futures on the index. We happened to pick the low point in the dividend futures market and the market has bounced back over the past 10 days as the increasing amount of stimulus has lifted the outlook for dividends. In this update we have enhanced the analysis and show that the fair value of S&P 500 is still 20% below the latest price.
Due to the volatility in dividend futures we smooth it out by calculating the 5-day average of the volume weighted average price of the 2021 Dividend Futures contract which is currently $39.82 and considerably lower than the 12-month rolling dividend per share in the S&P 500 at $60.61. Next we compute the monthly dividend yield, earnings yield and payout ratio since 1995 to get a range of potential valuation levels to take us from the 2021 dividend futures to a fair value distribution of the S&P 500.
Since 1995 the average dividend yield is 1.9%, average earnings yield is 5.3% and the average payout ratio is 35.8%. The total distribution of fair value is then the 5-day average price of the 2021 dividend futures multiplied by the inverse dividend yield. But the fair value of earnings per share is a bit more cumbersome. One thing is the range in earnings yield but the expected 2021 dividends also have a range of potential earnings per share driven by the payout ratio. So we generate expected earnings per share figures from the payout ratio and then multiply those by the inverse earnings yield to get to a range of fair values. In total we get 92,112 estimates for the fair value of S&P 500 leading to a distribution showing the most likely fair value range.
The average is 2,205 and the median is 2,126 which points to sentiment being too positive against expected dividends and earnings in 2021. In our view the latest rally is mostly technical driven by short positions being closed but also investors betting on the massive stimulus will create a V-shape recovery. We are still not buying this thesis and lean more towards a L-shape recovery or at best a U-shape recovery.
There are several ways to convert this into a trading position. The obvious one is a short position in US equities either through a CFD, future or option. Another way is to buy fundamentals (that’s being long dividends) and short sentiment (in this case US equities). This can be done again through futures. If one doesn’t have access to dividend futures one can make a synthetic long dividends bet by getting long exposure to ETFs tracking dividends stocks (potentially the dividend aristocrats as one needs exposure to those that can maintain dividends) and sell US equities.
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