Why the Math Doesn’t Work for Today’s Market

With interest rates low and stock valuations distorted, how much cash that companies give back to investors is more crucial than ever

By Steven Russolillo

     Traders at the New York Stock Exchange last week Photo: Spencer Platt/Getty Images

Stock valuations rise and fall, but when an important factor driving market performance is mathematically unsustainable, it is worth a closer look.

That is especially true now when ultralow interest rates make it easy to rationalize stocks at almost any valuation. At minimum, depressed interest rates allow the market to stay higher for longer than under more normal circumstances.

One factor that could end this game is how much cash companies are giving back to investors.

It is no secret that companies that pay healthy dividends or buy back stock, usually both, are the most popular kids in the class this year.

Aswath Damodaran, a professor at New York University’s Stern School of Business, sees this as the market’s biggest risk. Mr. Damodaran, who is considered an authority on valuation, says S&P 500 companies through the first two quarters of the year collectively returned 112% of their earnings through buybacks and dividends. That is the highest since 2008 and well above the 82% average over the past 15 years, he said in a blog post last week.

Mr. Damodaran, who likes to be provocative, says with rates this low, traditional valuation metrics are distorted. Instead, the inability of companies to keep paying off their investors will cause the next downturn. “This is the weakest link in this market,” Mr. Damodaran said in an interview. “We know cash flows will go down. What we don’t know is what the market is pricing in.”

Meanwhile, S&P 500 companies have logged four consecutive quarters of shrinking profits and tepid sales. That could force companies to buy less of their own stock and would take away a pillar of support for this market.
With earnings growth expected to be tepid in the coming quarters, maintaining dividends and repurchasing stock will only become more difficult. That trend might have already started. By one estimate, the value of stock-buyback announcements in the second quarter slowed to its lowest level in four years.
The S&P 500 hovers near records, up more than 6% this year. In this rarefied air, watch for turbulence.

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