Secular valuation contraction
Comment of the Day

November 17 2011

Commentary by Eoin Treacy

Secular valuation contraction

Eoin Treacy's view We have described the fundamental condition on Wall Street since early 2000 as a secular process of P/E ratio contraction and rising dividend yields. This is not the first time such a process of consolidation and rationalisation has occurred and it will not be the last. P/E ratio contraction followed the 1929 crash and the Dow Jones Industrial Average's 15-year range from 1965 to 1982 represented a similar condition.

Sometimes it is challenging to appreciate the length, breadth and volatility of these long-term cycles because of the amount of time involved and the difficulty in accessing enough fundamental data to depict them. This is why I was delighted to find a website which delivers very long-term charts of P/E ratios and dividend yields for the S&P 500 as well as long-term 10-year Treasury yields.

The long-term P/E ratio chart for the S&P500 hit important peaks in 1929, 1965 and 1999. It has been trending lower since 1999, in line with our secular valuation contraction hypothesis. The S&P Index by comparison has been mostly rangebound for the last decade and expectations of future upside potential have deteriorated.

I clicked through the constituents of the S&P 500 this morning using 20-year charts. I was looking for shares that reflected the secular valuation contraction theme and that showed positive upside potential. This list of 60 companies represents charts that struck me as interesting. I ranked them by subgroup, then dividend yield and have highlighted those that S&P defines as dividend aristocrats. (Note, S&P define a US dividend aristocrat as a company which has increased its dividend every year for at least 25 years.)

I have posted a number of reviews over the last couple of months focusing on US shares that were either exhibiting relative strength or hitting new highs. Please see Comment of the Day on August 28th for a review of the S&P 100 and September 7th for a list of shares hitting new highs.

In the consumer/cosmetic/toiletry sector, Johnson & Johnson (3.46%), Proctor & Gamble (3.24%) and Kimberly Clark (3.93%) have been largely rangebound for a decade. They have competitive yields, established global franchises and are leveraged to the growth of the global consumer.

In the pharmaceuticals sector Abbott Laboratories (3.51%), Bristol Myer Squibb (4.29%) share similar characteristics to the above shares. Elsewhere in the healthcare sector, Quest Diagnostics (0.73%) has been ranging mostly above $50 since 2005 and a sustained move above $60 would suggest a return to medium-term demand dominance.

Retailer, Walmart (2.45%) has been largely rangebound for a decade but is currently testing the upper boundary and a sustained move above $60 would likely indicate a return to medium-term demand dominance.

In the luxury retail sector, Tiffany (1.42%) completed a decade long range last year and found support above it in August and October. A sustained move below $60 would be required to begin to question medium-term scope for additional upside.

In the food sector, Heinz (3.53%), Kraft (3.3%) and Sara Lee (2.52%) all also have global franchises and respectable dividend yields. Coca Cola (2.76%) in the beverage sector also shares a number of characteristics with the above companies.

In the mining sector Newmont Mining (1.2%) hit a peak near $60 in 1996 and has until recently failed to sustain a move above that level. Provided it holds the recent breakout the benefit of the doubt can continue to be given to the upside.

The technology sector does not tend to pay out the kinds of dividends evident in the above sectors. However, there is no denying that it has a global reach. Google hasn't been around for as long as the above shares but has been largely rangebound since late 2009 and is now re-challenging the $600 area. A sustained move above $600 would confirm a return to medium-term demand dominance. Microchip Technology is marginally above its 2000 peak and the upside can probably continue to be given the benefit of the doubt provided it holds above the $30 region.

I have now also been able to extend to over 100 years the chart I created on Monday, showing the spread between Treasury yields and the dividend yield on the S&P 500. I believe this data is courtesy of Robert Shiller and the Federal Reserve and can be found on

The norm from the late 1880s through to 1950 was for equities to yield considerably more than US Treasuries. The perception was that they were a substantially riskier asset class and investors needed to be compensated for the additional downside potential. That all changed from 1950 as the post war bull market created additional demand for equities, companies began to expand overseas and inflationary pressures mounted.

The spread peaked in 1980 at just over 10% and has been compressing since. It has now returned to zero which represents a level where Treasuries and equities yield about the same. It is therefore an interesting time to ask whether equities or bonds are likely to yield more over the next 20 years?

The answer will depend greatly on one's focus. There are still a large number of globally oriented companies that do not pay dividends. For example, despite the rather attractive yields on some of the shares listed above, the average yield on the list of 60 shares I selected is 0.53%. The S&P currently yields 2.04%. Globally oriented companies have been increasing their dividends most others are still hoarding cash for R&D, takeovers or perhaps to shield against a worst case economic scenario.

Consumer related shares were relative wall flowers over the last decade but exhibit some of the most consistent chart patterns evident today. Globally oriented companies with solid cashflows and the ability to profit from the rise of the global middle class offer a solid growth trajectory supported by a competitive dividend. Those listed above are not leaders, Nike, McDonalds, Yum Brands, IBM, Apple, Colgate Palmolive etc. are in that category and have been reviewed recently.

The secular process of valuation contraction has not ended on Wall Street. The hollowing out of the US middle class is still a problem. The compression of US Treasury yields reflects these concerns. Volatility, corruption, deteriorating governance, high unemployment and falling housing prices all conspire to sap confidence. However, the newly minted global consumer, primarily in Asia, is not particularly affected by these concerns. Companies that are more leveraged to growth in that part of the world are more likely to outperform over time. The issue for investors is whether they would rather hold the liabilities of a government which has yet to outline how its obligations are going to be met or the shares of companies profiting from the elevation of billions of people out of poverty and into the middle classes.

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