The Impact of Company Earnings and Dividends on Investment Returns

This year, the stock market has showcased remarkable resilience, buoyed by an economy performing better than many anticipated. This positive momentum has been a boon for numerous investment portfolios, helping them to bounce back from the challenging bear market phase of the previous year. As investors look ahead, there’s growing optimism that this upward trend will bolster corporate earnings, which are traditionally aligned with market trajectories over extended periods. But in a landscape still marked by economic uncertainties, how are signs of potential profitability gains emerging for companies?

As we near the conclusion of the third quarter’s earnings season, an impressive 94% of S&P 500 companies have already disclosed their financials. Surprisingly, FactSet reports that a whopping 82% of these companies exceeded earnings expectations, heralding an anticipated 4.3% surge in year-over-year earnings-per-share growth. This upturn marks a significant milestone – the first instance of positive growth in a year, reflecting the economy’s unexpected steadiness. Wall Street’s consensus projects a static earnings scenario for this year at around $217 per share but anticipates a robust 11% jump in 2024. Although these projections somewhat contradict the forecasts for a slowing economy, any uptick in earnings will undoubtedly be a welcome development for investors.

Earnings growth may have reached an inflection point
Earnings growth may have reached an inflection point

Unraveling the Complexities of Corporate Earnings Growth

The trend in corporate earnings growth is intriguing. After reaching its zenith in 2021, there’s been a noticeable deceleration, but recent data suggest a possible turnaround. Historically, large corporations have managed to augment their earnings by about 7.7% annually, albeit with variations reflecting the economic cycle’s ebb and flow. Simplifying the earnings cycle: in prosperous times, sales outpace expenses, leading to enhanced profits and margins. Conversely, during downturns, slowing revenues compel companies to slash costs to preserve margins, setting the stage for increased profitability once economic conditions improve.

It’s a well-acknowledged fact that profits are crucial and, over extended periods, should mirror the value creation by companies. Business owners, executives, and corporate boards are invariably motivated to sustain and increase profitability, thereby enhancing shareholder returns. This emphasis on profitability is critical for investors for three key reasons.

The stock market tends to follow corporate earnings
The stock market tends to follow corporate earnings

The Stock Market's Correlation with Corporate Earnings

Primarily, the stock market’s long-term trajectory generally mirrors corporate earnings. An analysis shows that although there’s no exact alignment between S&P 500 prices and earnings, they tend to follow similar broad patterns. Economic growth fuels earnings, which in turn elevate stock prices. Hence, while the economy and stock market are distinct entities, their interconnection through corporate performance is unmistakable.

Secondly, the valuation of the stock market – whether deemed ‘cheap’ or ‘expensive’ – hinges not just on stock prices but significantly on corporate performance, particularly earnings. The price-to-earnings ratio, a crucial metric, is influenced not only by stock prices but also by earnings dynamics. This implies that even with stable prices, rising earnings can render the market more appealing, and the reverse is also true. The S&P 500 price-to-earnings ratio currently stands at 18.7 times the forecasted earnings for the next twelve months, higher than the historical average but significantly lower than the peak in 2020. This ratio will likely become even more favorable if earnings growth gains momentum.

Dividends are an important consideration for all investors
Dividends are an important consideration for all investors

Dividends: A Key Aspect of Investment Returns

Lastly, dividends play a pivotal role in investment returns. From a corporate standpoint, dividends are a mechanism to distribute cash to shareholders, particularly when reinvestment opportunities within the company are limited. Typically, companies aim to offer steady dividends to attract investors and, if possible, grow these payouts over time. However, it’s noteworthy that some sectors, especially within the technology realm, are known for lower dividend yields, often opting to retain more cash reserves.

For investors, dividends are an essential component of total returns. Historically, dividends, rather than price appreciation, were a primary investment motive. Today, while many investors focus predominantly on stock prices, dividends remain crucial, especially for those requiring portfolio income, such as retirees.

Despite the volatility of the market and the increase in bond yields this year, several sectors still offer attractive dividend yields. Underperforming sectors like Real Estate, Utilities, and Energy yield close to 4%. On the other hand, sectors with the most significant price appreciation, such as Communication Services, Consumer Discretionary, and Information Technology, exhibit the lowest yields. Therefore, investors should avoid making decisions based solely on recent performance or dividend yields. A diversified approach across various sectors is beneficial, particularly if earnings continue their upward trajectory.

A Focus on Long-Term Economic and Earnings Trends

The interconnectedness of economic growth, corporate earnings, and stock market performance cannot be overstated. For investors striving to achieve their financial objectives, keeping an eye on these longer is crucial.

Disclaimer
The content on this site, provided by Able Wealth Management, is purely informational. While we aim for accuracy and completeness, we cannot guarantee the exactness of the information presented. The views and analyses expressed in this blog represent those of the authors at Able Wealth Management. They should not be considered as investment advice or endorsement of any particular financial instrument or strategy. Any references to specific securities and their performance are purely informational and should not be taken as advice to buy or sell.Before implementing any information or ideas presented, we strongly advise consulting with a financial advisor, accountant, or legal counsel. Investing carries inherent risks, including potential capital loss. Asset values can fluctuate over time and may be worth more or less than the original investment. Past performance does not guarantee future results, and Able Wealth Management cannot ensure that your financial goals will be achieved. Information from third-party sources has not been independently verified by Able Wealth Management. Although we trust these sources, we cannot assure their accuracy or completeness.

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Volatility Drag

Volatility drag, often unnoticed by many investors, plays a significant role in the performance of investment portfolios, especially in markets characterized by high volatility. Understanding volatility drag is crucial for making informed investment decisions and managing long-term investment performance.

Understanding Volatility Drag

Volatility drag refers to the negative effect of investment volatility on compound returns over time. It occurs because losses have a more significant impact on portfolio value than gains of the same magnitude. For example, if an investment loses 10% one year and gains 10% the next, the investment will not return to its starting value due to the mathematical asymmetry between gains and losses. This phenomenon underscores the importance of minimizing large fluctuations in investment value to protect long-term returns.

The Mathematics Behind Volatility Drag

The mathematical principle underlying volatility drag is relatively straightforward but profound in its implications for investors. The key concept is that percentage gains and losses are not symmetrical. A 50% loss requires a 100% gain to break even, not a 50% gain. This asymmetry means that volatility (up and down movements in price) can erode the compound growth rate of an investment, even if the arithmetic mean of the returns seems healthy.

Example of Volatility Drag

Consider an investment with the following annual returns: +20%, -15%, +10%, and -5%. While the arithmetic mean of these returns might suggest a modest positive performance, the compound annual growth rate (CAGR) would tell a different story, factoring in the volatility drag and showing a lower effective return than the arithmetic mean would suggest.

Implications for Investors

  • Risk Management: Understanding volatility drag emphasizes the importance of risk management strategies, such as diversification and the use of derivatives for hedging, to minimize significant downturns in portfolio value.
  • Investment Strategy: Investors might consider investment strategies that aim for steady, consistent returns over those with potentially higher but more volatile returns. Such strategies might include investing in low-volatility stocks, index funds, or using dollar-cost averaging to mitigate the impact of market fluctuations.
  • Psychological Aspects: Volatility drag also highlights the psychological challenge for investors who may overreact to short-term market movements. A long-term perspective is crucial for successful investing, as frequent trading in response to volatility can exacerbate the drag on returns.
  • Performance Evaluation: When assessing investment performance, considering both the arithmetic mean return and the compound annual growth rate (CAGR) can provide a more comprehensive view of an investment’s performance, factoring in the effect of volatility.

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