Dividend futures suggest potential 37% downside in S&P 500
Head of Equity Strategy
Summary: S&P 500 dividend futures Dec 2021 is currently pricing in dividends at $33.85 which is 47% lower than the peak in February and suggest a dramatic reduction in companies' profitability over the coming years. Based on assumptions of dividend yield, payout ratio and earnings yield and given that the dividend futures are currently pricing dividends in 2021 then the fair value of S&P 500 is somewhere around 1,600-1,700 or 37% lower from current levels. It's important to stress that all financial predictions these days come with high uncertainty but dividend futures nevertheless gives investors a valuable input to their investment decisions.
Despite US equities have come back from the abyss in March the S&P 500 Dividend Futures Dec 2021 (read the last section for an explanation of a dividend future) has continued to decline hitting $33.85 in yesterday’s close. That’s a 47% decline from the peak February and provides market participants with important information about the expected future profitability of companies as COVID-19 hits the economy.
Dividend futures contracts have only been trading since 2015 and thus this is the first recession for this new instrument. We are used to have analysts to come up with forward estimates on earnings and dividends, but the problem with these estimates is that they come with no ‘skin in the game’. In other words, the analysts are not gaining or losing anything from their prediction except maybe a bad or good review from their supervisor. Dividend futures are derivative contracts with actual bets placed by market participants on future dividends paid by companies and thus the information value is significantly larger. This is probably the best indicator on the future prospects of companies in the US.
The market is pricing in dividends in 2021 to be $33.85 and off this number we can make assessments about the current equity valuation of S&P 500. Dividends lag quite a bit the economic realities of companies which we observed during the financial crisis. Dividends didn’t decline much in 2008 despite the recession and then fell 17.1% in 2009. If we assume that the market price of 2021 dividends is correct for now and apply the 2.12% dividend yield investors were willing to pay by December 2009 then the S&P 500 should be valued around 1,600 or 37% lower from current levels. It’s probably fair to say that the uncertainty around future profitability is high right now but at least we have a real-time contract providing input to our valuation of S&P 500.
A different angle is to reverse-engineer EPS from the market price of future dividends. The payout ratio (how much of earnings are paid out in dividends) in the S&P 500 has fluctuated around 36% since 1995. The payout ratio was 40% in 2009, so if we apply same ratio then EPS is potentially $84.63 in the S&P 500 by December 2021 down 44% from current levels. In order to get back to a value on the S&P 500 we need to consider what earnings yield to apply. US investment grade corporate bonds are right now yielding 3.5%. If we assume approximately same yield in 2021 and apply a 1.5%-points risk-premium for assuming the equity risk then we get to a 5% earnings yield which applied to our previous EPS number gives a valuation of 1,700 for the S&P 500. Better than our pure dividend yield model, but still significantly down from current levels around 2,500. The big joker on earnings yield is future inflation, but that’s a discussion for another day.
What is a dividend future?
A divide future is an exchange-traded derivative contract that allows investors to bet on future dividend payments. Let’s say an annual dividend future on company X trades at $0.90 and the company has recently paid $0.25 in dividends per quarter then if the company continues to do that over the entire year then the settlement price will be $1 on the dividend futures contract and the investor that bought the contract would profit $0.1 per contract.It allows investors to invest relatively against the consensus view of fundamentals for either a company or an index. Dividend futures can also be used to hedge exposure to dividend payments which is often a problem for options traders. Another interesting observation has been the historical relationship between dividend futures and inflation growth, so dividend futures can be used to hedge inflation.