A New View of Future Expectations for the S&P 500

Now that Eugene Fama, Lars Peter Hansen and Robert Shiller have collectively been awarded the Economics Nobel prize for their insights into how asset prices work, insights that we both routinely apply and have extended in our own work, we'll take this opportunity to open up a new window for how all that applies to the S&P 500.

We'll do that by remaking our favorite chart - the one that shows how changes in the year-over-year growth rate of today's stock prices keep pace with changes in the year-over-year growth rates of the dividends per share that are expected at specific points of time in the future - replacing the dividend futures data we obtain from IndexArb with dividend futures data from the Chicago Board of Exchange, which are really different from one another. The chart below shows all that data for each future quarter's dividends going all the way from 3 January 2013 through 10 October 2013:

Each of the data series that apply for a future quarter's dividends per share represent the expectations that investors have for the amount of dividends they will earn in that quarter. In the absence of large sources of noise, or variance, changes in the growth rate of stock prices will closely track with the trajectories associated with a specific future quarter where investors collectively focus their forward-looking attention.

In the chart above, we see that's the case at the very beginning of 2013, where investors focused their attention on the expected future defined by the second quarter of 2013 in setting stock prices. The focus of investors remained on that quarter, which ended in June 2013, well into April 2013.

At that point, investors began shifting their forward-looking attention to the more distant future defined by the expectations for dividends associated with the first quarter of 2014. We observe this shift in focus in the transition of daily stock prices (the dotted blue line) from the data series for 2013-Q2 to 2014-Q1.

That attention stayed there until 19 July 2013, when stock prices suddenly deviated from where investors were focused in response to what we've called the Bernanke Noise Event. Here, investors reacted to the new information that Fed Chairman Ben Bernanke communicated at a press conference that the Fed was seriously considering tapering off its purchases of government-issued securities once certain economic targets were hit by sending stock prices considerably lower than they would otherwise have been set if only the expectations of future dividends to be paid in 2014-Q1 were driving them.

That reaction was more than the Fed was ready to handle at that time. It took a month of effort, but the Federal Reserve finally succeeded in restoring the expectation that investors previously had that there would be no tapering of its QE programs until 2014, which we observe in stock prices resuming to closely track the expectations for 2014-Q1's dividends. But then, positive economic data combined with statements by lesser Fed officials led investors to believe that the Fed could begin tapering its QE program before the end of the third quarter of 2013.

That set off a larger negative reaction in stock prices. Only here, investors shifted their focus away from the more distant future quarter of 2014-Q1 in setting stock prices to instead fully focus on the critical quarter of 2013-Q3. We observe that shift taking place from the end of the Bernanke Noise Event through the end of August 2013, which marked the high point for the expectation of investors that the Fed would being tapering its QE programs in September 2013.

And then, the real-time economic outlook for the U.S. economy began to take a turn back to the worse, leading investors to increasingly bet that the Fed would not act to cut back its QE programs at the end of 2013-Q3, which led to rising stock prices as investors refocused their attention toward 2014-Q1. The Fed then surprised many, including us, that it would not act in 2013-Q3 to trim its QE bond-buying spree, but in retrospect, the evidence from stock prices and the expectations for future dividends supports that interpretation of events.

Unfortunately, before they could make it back to the level that would be fully consistent with the expectations associated with 2014-Q1, a new negative noise event centered around the potential for a government shut down and partial default on the nation's debt reared its ugly head, causing stock prices to once again deviate away from the level they would otherwise be. And that brings us nearly up to the present.

If all this makes the stock market sound like a chaotic place, that's because it frequently is - but that doesn't mean there isn't a predictable order underlying it all. That's what lies beyond the work of newly-minted Nobel-prize winning economists Fama, Larsen and Shiller, whose work has made what we do possible.

Speaking of which, if you want to find out more about our work, it all begins here. You only have to review several years of worth of what we've worked out live, in real time, without the benefit of any sort of safety net to catch up to us!...

Notes: we've modified the chart in this post from previous versions by eliminating an additional scale factor of 12 that we were applying to both the changes in the growth rates of dividends and the change in the growth rate of stock prices, which was an artifact our annualizing the monthly data we were using when we first discovered the relationship between the two. Since this additional scale factor is applied to both dividends and stock prices, it effectively cancels out of our math describing how changes in the growth rates between the two are related, so we're taking this opportunity to dispense with it altogether.

Beyond that, we've also changed our amplification scale factor, which is the scale factor that matters in our math. This change was driven by our change in data sources, where there can be considerable differences between the dividend futures data reported by IndexArb and that reported by the CBOE. Using IndexArb's data, we had settled on a typical amplification scale factor of 9.0, while the factor we're opting to use for the present with the CBOE's data is 5.0.

The Differences Between the Expected Futures for Dividends

We've previously discussed our sources for where we obtain the dividend futures data we use to track what investors expect at different points in time of the future, but we haven't shown how they compare with respect to one another, much less to how actual dividends per share play out!

We going to do that today using data for the just-ended third quarter of 2013. Our chart below shows how the data for 2013-Q3's expected cash dividends per share tracked from 3 January 2013 through the end of the calendar quarter on 30 September 2013:

As we noted before, the main difference between our primary sources of dividend futures data is how they determine how much the cash dividends per share will be at the end of the quarter they track. The Chicago Board of Exchange (CBOE) dividend futures contract uses a "top-down" approach, where the price of the contract is set by futures trading activity (if you access their data, the reported value is ten times the expected cash dividends per share for the quarter, so be prepared to shift the decimal point accordingly).

Meanwhile, IndexArb uses a "bottom-up" approach, which takes expected dividend per share data from each of the S&P 500's component companies and weights them according to their market capitalization within the index to create its expected cash dividend per share value. IndexArb also complicates its reporting for future quarters as the information it provides really indicates the total amount of estimated dividends per share for the index that will be paid out between the present (today) and the end of the dividends futures contracts upon which they're based.

That means that to find the expected amount of dividends per share that will be paid out in a given quarter, you have to take the total amount of dividends per share that will be paid out by the end of that quarter and subtract the total amount of dividends per share that will be paid out by the end of the preceding quarter. So, if we want to do find the value for 2013-Q3, we have to subtract the dividends per share that would be paid out by 2013-Q2 from it!

That creates some problems, which you can see in the chart above. Here, the data for 2013-Q3 from IndexArb effectively flatlines at the expiration of the dividend futures contract for 2013-Q2 on the third Friday of June 2013 (21 June 2013), because the futures data for the preceding quarter is no longer available for us to do that subtraction operation.

We can also see differences in how the values start and change over time. Here, the CBOE's dividend futures data starts and a higher value than IndexArb's, but is subject to greater volatility, which you would expect given how its value is set.

The IndexArb data is less volatile, and although it begins at a lower value, we can see that it converges toward the values that the CBOE projects, at least through the end of the preceding quarter's data. Based on the trend we observe in the data before that time, we think that the two would converge very close to each other by the actual expiration of the dividend futures contracts on 20 September 2013.

Meanwhile, both of the expected dividend values for both sources fell short of the actual level of cash dividends per share of $8.909 that S&P reported for 2013-Q3 after the end of the calendar quarter on 30 September 2013.

We think the primary source of the discrepancy between the dividend futures and the actual value for cash dividends per share can be traced to the estimate of each S&P 500 component company's weighting within the index. S&P is the final arbiter of those values, while estimates used by others are just that - estimates. We should also note that there is also a bit of mismatch between the terms of the dividend futures contracts and the dividends that are paid out by the ends of the calendar quarters that S&P reports, which may also account for a good portion of the discrepancy between the futures and the actual data once it is reported.

Given our experience in tracking the data, what we find to be really remarkable that the dividend futures data is typically within a 3% margin of S&P's officially recorded value (that's true even of the three-month earlier cutoff for IndexArb in the absence of a real market-shaking event), and often, is within a much closer margin of error than that.

Speaking of which, since the CBOE data stays "live" longer than the IndexArb data, our next update of our favorite chart will be based solely on the CBOE's data, which we're going to unveil tomorrow. We were going to wait to do that development until our annual end of year hiatus, but it turned out to be a snap to do, and there's some really interesting insights that come out of it!

Image Credit: Schweitz Finance.

Data Sources

EODData. Implied Forward Dividends September (DVST). [Online Database]. Accessed 7 October 2013.

IndexArb. Dividend Analysis. [Online Data Report]. Accessed daily from 3 January 2013 through 21 June 2013.

Standard and Poor. S&P 500 Index Earnings and Estimates. [Excel Spreadsheet]. Accessed 7 October 2013.

A Microrecession Dead Cat Bounce?

We may have been too optimistic last month in noting the end of a year-long period of microrecession in the U.S. economy.

Here, we've been tracking the number of public U.S. companies that have been announcing decreases in their dividends each month. August 2013 had seen the number of U.S. companies acting to cut their dividends drop below the key level of 10 per month, which we've previously observed marks the boundary between a growing U.S. economy and a U.S. economy that is experiencing recessionary conditions.

The data for September 2013 is now out, and the early suggestion is that the U.S. economy is not yet out of the woods.

As we ask in the chart, is this a proverbial dead cat bounce (a one-time event as the number of companies acting to cut their dividends bounces back into recessionary territory) or is the U.S. economy experiencing the same kind of recessionary conditions that characterized the entire year from July 2012 through July 2013?

There are two things of which we can be sure. Neither the impact of the partial U.S. government shutdown, which didn't even begin until 1 October 2013, nor the potential impact of a U.S. Treasury default on the U.S. national debt that President Obama has planned for 17 October 2013 are responsible for this outcome.

Instead, since the number of public U.S. companies announcing dividend cuts each month is perhaps the single best indicator of the real-time health of the private sector of the U.S. economy, what the data for September 2013 really suggests is that the U.S. economy is quite not as strong as the previous data indicated.

And that could be a more significant factor in driving today's stock prices than the increasing level of political noise emanating from Washington D.C.

Image Credit: InvestmentPaths.com.

The Conveyance Effect

Occasionally, our readers keep us on our toes by asking really good questions. Today, we're going to share part of an e-mail exchange we recently had, in which we get into the nature of when, where, why and how the analytical methods we've developed to anticipate what stock prices will or should be will work. We reckon its a good time to fit that discussion into a regular post since we doubled up on our ongoing series of weekly observations on how the S&P 500 is behaving last week, and because its always a great time to identify and describe a phenomenon that many professional investors may not even know exists.

Here's the e-mail that kicked off the discussion, followed by our response, which we've enhanced by adding links and charts, as well as some text for clarification in boldface font. Enjoy!

I have really been enjoying the S&P 500 posts lately concerning index value vs. trailing year dividends.

Not to make things more complicated than they need to be, but have you ever considered breaking it down into sectors? Would that help to explain even further what is going on in the market?

I ask this question because I think of things like the 2007-2009 market decline. If you just look at the S&P500 index value, you may not have realized the market was in a major decline until early to mid 2008. If you looked at the sectors (e.g., XLB, XLE, XLF, XLI, XLK, XLP, XLU, XLV, XLY) you would have seen that most of the market sectors were in decline since 2006 or 2007, except for energy and basic materials. They were keeping the index afloat. It would only be a matter of time before they collapsed, too.

I realize that looking at your index vs. trailing year dividends, it's much more obvious that something was up with the market, going from order, to disorder. I just wonder if it would be even more clear if it was broken down on a sector by sector basis.

Thanks for your comments and question!

The main challenge for what you describe is the available data. While it's easy to get the market-cap weighted values for each sector's stock prices, getting market-cap weighted dividend data for the various sectors is a little more difficult (we would have to take each component stock's projected future dividends per share for each sector and weight them according to their market cap within the sector, which would be pretty time consuming.)

Aside from that, we would also see greater volatility in the price portion of the data, since we would be looking at a smaller section of the market.

Apple provides a pretty good example of what we mean here. Individual stock prices, like Apple's, are really volatile over time, as there is often a lot of speculation (or noise) affecting them in addition to the more fundamental driver of their dividends (or signal). If you recall last year, Apple's stock price ran up considerably in the months and weeks leading up to their announcement that they would initiate a cash dividend on the speculation that they would do so.

After they announced it, Apple's stock price began to fall. But the S&P 500, of which it became the largest component, did not, even though it had been rising with it.

The reason why is because of an effect that we'll call "conveyance". Here, Apple's stock price rose on the speculation of investors who on having bought on the rumor, after their dividend announcement, sold on the news.

Much of that money stayed in the stock market, going to buy other stocks as investors sold off their shares of Apple as they rebalanced their portfolios. That rebalancing, in turn, allowed the S&P to keep rising (and sustain its value), keeping in tune with the index' increased level of dividends. In effect, Apple's dividend was conveyed throughout the entire index, supporting its (the index') valuation, even though Apple's stock price itself fell in the weeks and months that followed.

We capture that effect in looking at the entire index, but can lose the strong correlation when looking at sectors or individual stocks, where the conveyance effect can be affected by investors rotating into or out of particular sectors or stocks, making them much more volatile than the index as a whole.

---

Quick history: The starting and ending dates we selected for our charts above coincide with the date at which dividend futures contracts for 2011-Q4 and 2012-Q2 expired. The serious speculation that Apple would initiate a dividend began after the expiration of the 2011-Q4 futures contracts. Apple made the announcement that it would begin paying a dividend on Monday, 19 March 2013.

Its stock price was buoyed up for another three weeks as the speculative bubble inflated (see our third chart in this post), peaking on 9 April 2012 as investors finally began to realize that the company's stock price was getting too disconnected from where its own fundamentals would place it, after which the conveyance effect really kicked in.

You can see that in the second chart that we've added to our original exchange above, where most of the conveyance effect took place between 9 April 2012 and 30 April 2012, after which Apple's stock price and the rest of the S&P 500 resumed following mostly matching trajectories, which is what we should expect for the new 800-pound gorilla of the S&P 500.

Since the end of the Apple speculative bubble in May 2012, the S&P 500 has mostly followed a stable trajectory, as the market has largely continued in the period of relative order that began in August 2011.

Dividends: U.S. Economy Now Out of Recession

According to the number of publicly-traded U.S. companies announcing cuts to their dividends, as of August 2013, the private sector of the U.S. economy has now fully exited the period of microrecession that it first entered in July 2012.

This new data confirms our call last month that the U.S. economy was exiting the recessionary conditions that had bogged it down since the third quarter of 2012.

Not uncoincidentally, this period of time also coincides with the Fed's latest quantitative easing programs. If not for the Fed's QE efforts, the U.S. economy would have experienced a full-fledged recession, rather than the more limited microrecession that it did.

Now that the U.S. economy is leaving those recessionary conditions behind, is it any wonder that the Federal Reserve is ready to begin trimming back the acquisitions of mortgage-backed securities and U.S. Treasuries that make up its current quantitative easing programs?

If you're looking for something fun to consider, try answering this question: If the Federal Reserve had not intervened to avoid the effects of a full-fledged recession in the U.S. economy in 2012, would President Obama ever have been re-elected?

References

Standard and Poor. Dividend Action Report. [Excel spreadsheet]. Accessed 10 September 2013.

Dividends: U.S. Economy Exiting Recession

The number of public U.S. companies announcing that they would be cutting their future dividend payments fell from 20 to 14 in July 2013. While this level of dividend cuts announced in a single month is still consistent with recessionary conditions being present in the U.S. economy, it does represent an improving situation as it appears that the U.S. economy is beginning to exit the microrecession that began back in July 2012.

By our definition, a microrecession represents a period of slow or negative economic growth for the nation that is either too limited in scope, severity or duration to qualify as an official period of recession, as might be determined by the National Bureau of Economic Research.

We'll note that the Bureau of Economic Analysis' recently revised GDP data now confirms what our dividend indicator has been communicating in real time - the pace of economic growth in the U.S. has been in the "cold" recessionary zone, as indicated by our two-quarter GDP growth rate temperature gauge:

Prior to its revision, the BEA's GDP data had indicated that the U.S. economy was growing at a somewhat faster pace.

As best as we can tell, it appears that the microrecession peaked in the fourth quarter of 2012. The U.S. economy would now appear to be exiting this period of microrecession, which has now lasted for over a year.

References

Standard and Poor. Dividend Action Report. [Excel spreadsheet]. Accessed 5 August 2013.

U.S. Commerce Department Bureau of Economic Analysis. Current-Dollar and "Real GDP". [Excel Spreadsheet]. Accessed 31 July 2013. - Note: Inflation-adjusted figures are actually presented in terms of chained 2009 U.S. dollars (not chained 2005 U.S. dollars).

The Dividend Recession

In June 2013, there were 20 public U.S. companies that announced that they would cut their dividend payments going forward. Unfortunately, that's double the level that indicates that the U.S. economy is experiencing recessionary conditions.

In the chart above, we see that the number of U.S. companies slashing their dividends first tipped over the "recession line" back in May 2012, before dipping back for a single month in July 2012, and then remaining steadily above the line ever since, with one four-month long period of extreme volatility.

The extreme volatility in the data running from December 2012 through March 2012 coincides with the so-called "fiscal cliff" tax crisis. Here, after U.S. companies raided the future to pay out extra large dividend payments before the end of 2012 to avoid the risk of having tax rates on dividends almost triple in 2013, many of these companies then announced that they would be cutting their future dividend payments in two separate waves - the first before the end of 2012, and the second before the end of the first quarter of 2013.

The Bureau of Economic Analysis will be releasing a major, mulit-year revision of the nation's GDP at the end of July 2013 - it will be interesting to see if any part of the period since May 2012 will be reclassified as having experienced the negative growth that corresponds to periods of outright recession.

Whither Dividend Futures

Previously, we've discussed the role that dividend futures data, or rather, the quantified future expectations of investors, plays in setting today's stock prices. But where can you get dividend futures data?

We have two sources for dividend futures data. First, we regularly collect the distant futures data reported by IndexArb on its Dividend Analysis page, which reports the daily dividend futures data for the S&P 500, the Nasdaq 100 and also the Dow Jones Industrial Average. The image below represents a snapshot we took of the data back on 1 July 2013:

Originally developed to support trading based upon index arbitrage, which uses the data to help determine the "fair value" for stock index prices, what IndexArb is really reporting with these raw numbers is the amount of dividends per share expected to be paid out to shareholders for each index from the current day to the end of each of the indicated futures contracts, which expire on the third Friday of the month ending the indicated quarter.

So, if you want to find out what the quarterly dividend is for a given future quarter, you need to take the raw value provided in IndexArb's data and subtract the raw value for the quarter immediately preceding it.

For example, if we take the value for the S&P 500's dividends per share to be paid out by the end of the March 2014 contract of $26.474 and subtract the value for dividends per share to be paid out by the end of the December 2013 contract of $16.847 we find that investors would appear to be expecting that S&P 500 companies will be paying dividends of $9.627 per share in the first quarter of 2014.

Our second source of future dividends data for the S&P 500 is a bit easier to read to determine what level of dividends per share that investors expect to be paid in future quarters. That source is the Chicago Board of Exchange, which posts four separate dividend future options for the next four quarters, in which the price of each quarter's options is set to be 10 times the amount of dividends per share expected in the quarter. The table below provides links to the data for each of the CBOE's quarterly dividend futures contracts, along with the value we recorded back on 1 July 2013 for reference:

Data for Dividends for Future Quarter Ending in Indicated Month	Value Recorded on 1 July 2013
Implied Forward DVS Indicator - March	91.67
Implied Forward DVS Indicator - June	94.11
Implied Forward DVS Indicator - September	86.98
Implied Forward DVS Indicator - December	92.72

Although we presented the table in seeming chronological order, in reality, the earliest data belongs to the month ending the current quarter, which the other data following in order after that. For the data presented in the table above for 1 July 2013, the March and June contracts end in 2014, while the September and December contracts end in 2013.

Dividing the March contract data by that factor of 10, we see that this source expects that dividends in the first quarter of 2014 will be $9.167 per share. That's $0.46 per share less than what IndexArb's dividend futures expects, which in our experience, is really atypical, as they'll normally be within 5-20 cents of one another!

Why such a large difference between the two dividend futures for 2014-Q1? We suspect that the answer has a lot to do with how each of our sources determines their expected value of future dividends. IndexArb uses a "bottom-up" approach, where it takes the dividends that are expected to be paid by each company making up an index and then weights them accordingly per the companies' relative size within the index.

As part of that bottom-up build up, and in the absence of information indicating otherwise, IndexArb assumes that the actions of the past will be repeated in the future. For example, if a number of companies acted to boost their dividends by a particular amount in the first quarter of 2013, they assume they will boost their dividends by a similar amount in the first quarter of 2014.

By contrast, the CBOE's dividend values are determined through the trading of option contracts, with the price being set through more of a "top-down" process, where they start with the value expected for dividends in the future quarter, which is then adjusted through trading activity as new information about the future is absorbed. The value of the CBOE's dividend futures options is then particularly affected by news about the dividend plans of the most heavily-weighted components of the index, without necessarily considering all of the underlying changes occurring throughout the entire index that IndexArb captures.

In this case, it appears that the investors who have actively traded the CBOE's dividend futures contract for 2014-Q1 have made an assessment that the dividend hikes of the first quarter of 2014 are likely to be considerably less than the dividend hikes that were recorded for the first quarter of 2013. We believe that particular assessment was made on 13 May 2013, after it became clear that investors had shifted their forward-looking focus to the first quarter of 2014 in setting stock prices, which we observed in the form of a sudden downward shift from the CBOE's previously recorded value for this option on 10 May 2013. Only this particular future dividends contract changed its value this way at the time.

For our part, we're using a blend of the two sources in our ongoing market analysis, in which we're using the CBOE's futures data for 2014-Q1, but IndexArb's data otherwise. Here, we recognize a number of unique factors drove the dividend increases in the first and second quarters of 2013 related to the resolution of the so-called "fiscal cliff" tax crisis that will not be repeated in 2014, which we think the CBOE's data is capturing at present, but which we think that IndexArb's data is not as yet.

At some point in the future, we expect that the dividend futures represented by these two sources will converge toward each other as the quality of information regarding the future for dividends in that distant quarter improves.

The Fed's Real QE Mistake:Timing

Fed Chairman Ben Bernanke screwed up royally at his press conference on 19 June 2013, as he announced that the Fed's Open Market Committee had moved up its timetable for when it would beginning drawing down its QE 4.0 program.

QE 4.0, which consists of the Fed's purchases of a net total of $45 billion worth of U.S. Treasuries each month, was originally announced back on 12 December 2012 and was intended to offset the negative effects of the fiscal drag of impending tax hikes upon the U.S. economy in 2013. (Combined with the Fed's QE 3.0 program for buying up Mortgage-Backed Securities, which started back in September 2012, the Fed has been pouring $85 billion per month into the U.S. economy to avoid having it fall into a full blown recession.)

As best as we can tell, it is working as intended.

So why shouldn't the Fed begin tapering its net acquisition of U.S. Treasuries sooner? And why would making an announcement that the Fed was planning to do so be such a huge mistake.

In a single word: timing.

It's difficult to think of how the Fed Chairman could have handled the situation any worse, except perhaps to have put the responsibility for announcing the change in policy into President Obama's floundering hands.

But the key to understanding the huge mistake the Fed has made is not to look at the timing of when the announcement was made, as some influential people are likely to claim, but by considering how it changed the forward-looking focus of U.S. markets.

Investors in those markets are always looking ahead in time - the only real question is how far into the future are the market's most influential investors looking. And when we say "most influential investors", think of the primary owners and majority shareholders of businesses, as well as the people who make decisions at major investment banks and financial firms.

The reason why they do that is because what they expect to happen at certain points in time in the future directly drives their investment decisions. Those decisions, in turn, have tremendous influence over the prices of everything today.

That's because today's prices are really the approximate net present value of the sustainable portion of the profits that might be realized at discrete points of time in the foreseeable future (see here for a more refined definition). What that means is that if you can determine what the expectations are for given points of time in the future, you can work out exactly how far forward into the future the markets have focused in setting today's prices.

With that knowledge, you can then work out how today's prices will change based on changes in those future expectations. While that may sound challenging, in reality, it's complex, but not difficult to do.

For a stock market, the sustainable portion of profits that might be realized at discrete points of time are called "dividends". We can determine what the expectations are for a given point of time in the future by using dividend futures (via IndexArb or the CBOE) to calculate the change that is anticipated in their year-over-year growth rate. We make historic price, dividend and earnings data for the S&P 500 available for free so you can obtain that data as well.

Since late-April/early-May 2013, the U.S. stock market, as represented by the S&P 500, has been focused on the future as given by the expectations associated with the first quarter of 2014. Until about 2:42 PM on Wednesday, 19 June 2013.

At that time, Federal Reserve Chairman Ben Bernanke metaphorically grabbed the noses of the market's most influential investors and forced them to shift their focus away from the first quarter of 2014 to instead focus on an earlier point of time in the future, to either the third or fourth quarter of 2013, which would now coincide with the timing of when the Fed will begin to taper off its QE 4.0 net acquisitions of U.S. Treasuries. Our chart below shows why the Fed's choice of timing in resetting the focus of the market's most influential investors to these particular periods of time is so poor, at least with respect to stock prices:

We estimate that in transitioning from a forward-looking focus upon the first quarter of 2014 to instead focus upon the fourth quarter of 2013, which would be the worst case scenario, stock prices for the S&P 500 would fall on the order of 45-50%, after which stock prices would stabilize at the level prescribed by the expectations for dividends in 2013-Q4. Until perhaps investors could shift their focus to a more promising quarter in the more distant future or an improvement in the outlook for that quarter.

By contrast, shifting their focus even earlier to the third quarter of 2013 would be more beneficial, as that would only involve around a 15-20% decline in stock prices from their 18 June 2013 closing level of 1651.

This analysis assumes that Bernanke's comments succeed in shifting the forward looking focus of investors to an earlier future, which would mark a shift in the expectations for the fundamentals driving the market. At this writing, it is too early to tell if such a fundamental shift has occurred, which is why we are presently classifying the market's reaction as a noise event. Depending upon how the Fed responds to the markets' reaction, it is still possible at this writing to arrest and reverse the decline in stock prices.

Now, we've gone into such basics in this article because we know that Federal Reserve Chairman Ben Bernanke and his successor are going to read it and might like to finally learn a little bit about how things like stock prices actually work. And then, maybe, do something that would shift the focus of investors back to the first quarter of 2014, in a way that ensures the Fed's credibility is not damaged.

Because we're pretty sure the Chairman and his colleagues at the Fed don't want to have to bear the full responsibility for having followed up one colossal error on their watch with another, marked by a second monster stock market rout during their tenure. We just don't think that too many people would want to be able to claim that they surpassed the accomplishments of Roy A. Young, Eugene Meyer and Marriner S. Eccles, the Fed chairmen who oversaw the formation of the Great Depression and the Great Recession of 1937-38.

Dividends Still in Recessionary Territory

We were busy doing other things earlier this month, but here's the economic situation with respect to dividends in the U.S. stock market through May 2013:

With 18 public U.S. companies acting to cut their dividends in May 2013, the number of companies taking such actions is still consistent with recessionary conditions being present within the U.S. economy.

The level for May 2013 however shows some improvement over previous months, where the number of companies acting to cut their future dividends has been in recessionary territory in all-but-one month since May 2012. We should note that the level of dividend cutting activity in the U.S. was especially elevated from December 2012 through March 2012 as a consequence of the fiscal cliff crisis.

Since that time however, the number of U.S. companies acting to reduce their dividends has gone back to being a pretty solid indicator of general economic conditions in the U.S. We define "recessionary conditions" as being present whenever there are more than 10 public U.S. companies announcing reductions in their dividend payments to shareholders in a month.

References

For those who would really like us to consider a longer timespan in our analysis, if you would, please track down a good source of historic data for the entire U.S. stock market with respect to dividend changes and let us know where it is. Something similar to the following source, which only provides data going back to January 2004:

Standard and Poor. Dividend Action Report. [Excel spreadsheet]. Accessed 4 June 2013.

Of course, if you find such a high quality data source, you're more than welcome to beat us to the punch with your own analysis!...

The Great Dividend Raid of 2012

How much money did U.S. investors raid from the future following President Barack Obama's re-election on 6 November 2012?

We've long noted the tax-avoidance motive that investors had for taking this action, as well as the factors that drove its timing, but we've never fully quantified just how much money was involved in the great dividend raid of 2012.

Until today, that is! Our first chart shows how the amount of S&P 500 dividends per share expected to be paid out the fourth quarter of 2012 and the first three quarters of 2013 changed in the period from 21 September 2012 to 21 December 2012, while the chart immediately below it shows how the value for the S&P 500 changed during this period as well. We selected this three month long period because it covers all the time from the expiration of the dividend futures contract for 2012-Q3 on the third Friday of September 2012 through the expiration of the dividend futures contract for 2012-Q4 on the third Friday of December 2012.

The Great Dividend Raid took place from 15 November 2012 through 18 December 2012, which we can see in the changing values of each of the quarterly dividends per share expected for 2012-Q4, 2013-Q1, 2013-Q2 and 2013-Q3. During this period, cash that had been put aside to pay dividends in the future quarters of 2013 were pulled out of those accounts to instead be paid out to investors in the fourth quarter of 2012.

Our next chart reveals the amount of dividends per share that were transferred from 2013 to the fourth quarter of 2012:

Here, we find that some 60.5 cents per share worth of dividends was transferred from the funds meant to pay dividends in 2013 into 2012-Q4's dividend total instead. 62.5% (37.8 cents per share) of this amount came from the funds established to pay dividends to investors in 2013-Q1, 19.8% (12 cents per share) came from the funds to pay 2013-Q2's dividends and the remaining 17.7% (10.7 cents per share) was raided from the funds set to pay dividends in 2013-Q3.

That's the per-share total, but how much money is that exactly? To find out, we estimated the equivalent number of shares for the entire S&P 500 by taking the total market capitalization of the S&P 500 on 31 October 2012 ($13,372,974,540,810) and 31 December 2012 ($13,630,242,851,346) and dividing these values by the closing value of the S&P 500 on those days ($1,412.16 on 31 October 2012 and $1,426.19 on 31 December 2012). Doing this math gives us an equivalent number of shares for the S&P 500 of 9,469,872,069 and 9,557,101,684 for each date respectively. We then calculated the arithmetic mean of these values, which gives us the average equivalent number of shares for the S&P during our period of interest of 9,513,486,877 equivalent shares.

Multiplying 9,513,486,877 shares by 60.5 cents per share then reveals that approximately $5,755,659,560 ($5.76 billion) worth of dividends were pulled from 2013 into 2012, thus avoiding the higher dividend tax rates that were guaranteed to take effect in 2013.

Assuming these are all qualified dividends, which would be taxed at 2012's maximum dividend tax rate of 15%, the U.S. federal government saw an extra $863,348,934 ($863 million) worth of tax revenue for 2012 as a result of this action.

If this money had been taxed at the maximum rate of 43.6% that S&P 500 investors risked facing in 2013 if U.S. companies had not taken this action, the federal government would have added as much as $2,509,467,568 ($2.5 billion) to its tax collections for the 2013 tax year. We therefore find that investors actually saved as much as $1,646,118,634 ($1.6 billion) of the money they earned through the companies they own by raiding their future dividends to avoid the future's higher tax rates, which were guaranteed with the re-election of Barack Obama as U.S. President.

Fortunately, the future for taxes on dividends played out differently than this outcome, as the fiscal cliff tax deal on 3 January 2013 set the maximum tax rate for dividends in the U.S. at 23.8%. Going by that measure, S&P 500 investors still collectively saved as much as $483,475,403 by pulling these dividends into 2012 from 2013. That tax deal also changed the relative desirability of dividends with respect to wage and salary income, which is what really lies behind the rally in stock prices that ran from 3 January 2013 into April 2013, but that's a different story....

On a closing note, let's revisit our 11 February 2013 chart showing how the changes in the rate of growth of dividends per share and stock prices fared for each of these quarters during the period of the Great Dividend Raid of 2012:

Reviewing all the charts that we have presented, we find that there is no correlation between changes in stock prices and the timing of when the Federal Reserve's various changes in the implementation of its quantitative easing programs occurred during these final months of 2012. We therefore find that the Fed's QE programs had virtually no impact upon stock prices during this period.

We do however recognize a rather screaming correlation between changes in dividends per share and stock prices during the period of the Great Dividend Raid. Here, we find that the timing of the stock market rally beginning on 15 November 2012 follows the shifting of cash dividends from being paid in the future quarters of 2013 to be paid instead before the end of 2012. We recognize that the change in the amount of dividends expected to be paid in 2012-Q4 triggered the change in stock prices because the dividend futures for 15 November 2012 were actually recorded after the U.S. stock market closed on 14 November 2012, many hours prior to the beginning of trading the next day. The sequence of this timing establishes the role of changing expectations for future dividends as the primary causal factor in driving changes of stock prices (and really, is simply a recent but prominent example of the direction of causality.)

In addition, we recognize that the actual changes in the growth rate of stock prices directly paced the changes in the year-over-year growth rate of dividends per share expected for 2012-Q4 during the period of the rally, further demonstrating the role that expected future dividends play as the fundamental driver of stock prices.

It's not often we have sufficient data to junk the "correlation does not imply causation" caveat for analysis, while also debunking a widely held view that the Fed's latest QE programs may be causing a bubble to inflate in stock prices and simultaneously validating our theory and math for describing how stock prices really work.

Seeking Alpha commenters who want to know more should begin accessing our archives here.

The S&P 500 Enters a Post-Transition Period

You have to admit - we were right. Last week was indeed a big week for the S&P 500!

From Monday, 13 May 2013 to Friday, 17 May 2013, the S&P 500 rose by nearly 2%, or 32.35 points, from 1630.77 to a new record high of 1666.12. Over half the gain for the week came on Friday, 17 May 2013, as the S&P 500 rocketed up by 17 points.

In doing that, the S&P 500 completed the transition it began on 1 May 2013, as investors shifted their forward-looking focus from the second quarter of 2013 to the first quarter of 2014 in setting their expectations for the sustainable portion of future earnings growth for the stock market (a.k.a. "future dividend growth".) We can observe this transition directly in our chart below as the movement of the daily and 20-day moving average of the change in the rate of growth of stock prices from the red line representing 2013-Q2 to the green line representing 2014-Q1, which correspond to the change in the year-over-year rates of growth of the trailing year dividends per share expected for each of these quarters.

Now, even though this confuses the more dim-witted among Seeking Alpha's commenters, this latest transition of investor forward-looking focus from 2013-Q2 to 2014-Q4 follows very similar transitions that have taken place periodically since the end of the Federal Reserve's QE 2.0 program at the end of June 2011. Following the deflation of that mini-bubble in the weeks that followed, stock prices have since been very fundamentally-driven with little noisy exception, with the pace of acceleration of stock prices matching up with the changes in the growth rates of trailing year dividends per share for discrete future quarters.

The transitions of investor forward-looking focus from one future quarter to another, combined with changes in the growth rate of dividends expected in quarters where investors have focused their attention, accounts for nearly all but a small portion of the changes in stock prices that have occurred in the post-QE 2.0 period.

These periods of transition in forward-looking focus also mark the greatest uncertainty we have in anticipating the direction and change of stock prices over time, outside of significant noise events such as the Federal Reserve's quantitative easing programs marking major changes in their acquisition rates of U.S. Treasuries. That was definitely the case with QE 2.0, when the Fed ramped up then discontinued an interest-rate lowering bond-buying program, which resulted in the mini-bubble for stock prices.

However, that has not been the case with QE 3.0, where the Fed ramped up only its purchases of Mortgage Backed Securities in September 2012, or for QE 4.0, which began in December 2012, where the Fed maintained its ongoing acquisition rate of U.S. Treasuries that it set in its "Operation Twist", but stopped selling off an equal value of holdings that was the other part of that operation. The lack of change in the Fed's basic acquisition rate of U.S. Treasuries for both QE 3.0 and QE 4.0 is why these latest quantitative easing programs have had no significant impact upon stock prices.

Now that the pace of acceleration of daily stock prices has risen above the green line on our chart above, we can expect the recent rate of growth to taper off, and even to fall following this period of transition, as there is no fundamental support for stock prices to remain significantly above this level for any sustained period of time, absent some action by the Fed.

That brings us to this week, where a lot of focus will be upon the pronouncements of the Federal Reserve. At present, there are a number of indications of recessionary conditions being present in the U.S. economy, which the Fed might attempt to offset by amping up its purchases of U.S. Treasuries. The market's response to such a noise event would be the only reason for the latest rally in stock prices to continue at their current rapid pace of escalation, as the earnings season for the second quarter of 2012 is nearly over, leaving little time left for corporate earnings announcements and changes in dividend policies to affect stock prices.

Speaking of which let's take a closer look at that microtrend rally. Our following chart shows the upward rise of stock prices since 15 November 2013, nearly one month before the Fed began its QE 4.0 program, with respect to the S&P 500's trailing year dividends per share:

We mark the beginning of the newest microtrend rally in stock prices from 1 May 2013, which coincides with the divergence of stock prices from the level that is defined by the dividends that are expected to be paid by the end of 2013-Q2. The new microtrend rally is characterized by an even more rapid escalation rate for stock prices than seen in the period from 15 November through 30 April 2013, which is also something that we associate with transition periods in where investors set their forward-looking expectations.

We'll take a closer look at the longer trend in stock prices later this week....

A Big Week for the S&P 500

Going into this week, we're not much closer to knowing for sure if the stock market's climb from its last notable trough on 18 April 2013 is the result of noise, a fundamental shift in investor focus, or the Fed's recent indication that it might really amp up its current quantitative easing program as we have previously speculated it might.

But regardless, even if stock prices stay flat, this will be a big week for the S&P 500, because this is the week that three of the largest companies that compose the market-cap weighted index will be determining who owns their stock for the purpose of paying out dividends for 2013-Q2!

In fact, two of those three companies will be noting their shareholders of record today (Monday, 13 May 2013): Exxon Mobil (NYSE: XOM) and Apple (Nasdaq: AAPL). They just coincidentally happen to be the two biggest companies in the S&P 500, accounting for nearly 5.74% of the entire value of the index (at least, as of last Friday, 10 May 2013)!

The third S&P 500 heavy hitter who will be noting their shareholders of record on Friday this week is Chevron (NYSE: CVX), which is only the fifth largest component stock of the index, representing about 1.6% of the S&P 500's value.

Now, here's where things might get interesting this week. Focusing just on Apple and Exxon Mobil, who will be noting their shareholders of record today, if investors in these companies are primarily in the market to pocket dividend payments in this quarter, there's no incentive for them to continue holding these stocks in their portfolios after today. No matter what, as long as investors hold the stock they own in these companies through the end of the day, they will be paid the dividends they earned as stockholders of these companies in 2013-Q2, even if they turn around and sell their shares tomorrow or in future days.

Looking ahead to the near future, if they believe that share prices are likely to fall, then it actually makes sense for them to sell their shares after today. Doing so would then allow them to perhaps buy more shares back later when prices are lower, which would increase the yields they earn on their investments, or to perhaps do something different with their combined dividends and proceeds from selling their shares altogether.

But, if these investors believe that the stock prices for Apple and/or Exxon Mobil are likely to continue rising, then it's likely that they'll continue holding the shares they own and perhaps to add more shares to their portfolio now, while prices are lower than they expect they will be in the future, which will help contribute to rising stock prices in the near term.

Since Exxon Mobil and Apple together account for over 1/18th of the entire value of the S&P 500, we should be able to get a good idea of how investors believe the future will play out from observing how just these two stocks behave after today. That reaction, in turn, will help us determine if the run up in stock prices since 18 April 2012 is the result of investors shifting their focus to 2014-Q1 in setting stock prices or if it is just the result of a noise event, which tend to be pretty short-lived.

We'll close with our favorite chart, which shows that investors have spent much of the last week waffling in choosing the future they expect to play out, which kind of suggests that what we've seen recently for stock prices is likely the result of noise, but judge for yourself:

We'll be able to tell which future investors have finally selected as the acceleration of stock prices will converge with that distant future quarter's change in the growth rate of dividends expected for it. From 20 December 2012 until very recently, investors have been focused on the expectations for 2013-Q2 in setting stock prices, but we're running out of the available future left for investors to focus upon in that quarter....

Update 15 May 2013: Monday, 13 May 2013 actually marked the end of the period in which investors who owned stock in XOM or AAPL at the close of trading on 8 May 2013 would be included on the list of these stocks' shareholders of record. Investors wishing to collect dividends from these companies have been free to sell their shares since that time. Our thanks to the sharp-eyed reader who caught our error!

For our analysis however, the good news is that it didn't take long for the S&P 500 to prove it was going to have a big week!

After the Dividend Cliff

As expected, following the end of a record-breaking four-month long period in which publicly-traded U.S. companies incented by the fiscal cliff crisis set all-time records for the number of dividend increases, cuts and special (or extra) dividends paid, April 2013 was somewhat boring by comparison.

The recent rally in stock prices, beginning after 15 November 2012, is a direct result of these companies' reaction to the fiscal cliff crisis.

All in all, there were some 2,946 declarations made by the approximately 3,687 publicly-traded companies in the United States announcing some sort of action related to their companies' dividend policies. Of these, 36 involved companies paying an extra, or special dividend payment to their shareholders and 203 involved dividend increases. These figures are well below the all-time record levels of 483 extra dividends announced in the month of December 2012 and the 298 dividend increases announced in February 2013.

But the real news is that the number of U.S. companies announcing dividend cuts is continuing to be consistent with recessionary forces being at work in the U.S. economy.

We had expected the number of companies announcing dividend cuts to fall significantly after the first quarter, when many companies that had raided the funds they had set aside to pay dividends in 2013 to instead pay extra or special dividend payments before the end of 2012 to avoid higher dividend tax rates taking effect in the new year and unable to replenish them from their cash flow acted to cut their dividend payments for 2013. The all-time record of 93 U.S. companies announcing dividend cuts in a single month was set in December 2012.

Most of these extra dividends payments were specifically taken from the funds set aside to pay dividends in the first quarter of 2013. Consequently, most of these dividend cut declarations related to the amount of dividends that these companies would pay out in 2013-Q1.

Now that we're past the first quarter, this aspect of the U.S. federal government's fiscal cliff crisis is largely behind us and the number of companies acting to cut their dividends is once again above the level of 10 U.S. companies announcing dividend cuts per month that marks the dividing line between a U.S. economy that is "healthy" and one that is experiencing recessionary conditions.

It is however below the levels that were being recorded in second half of 2012, when the nation's economic growth slowed to a near zero-growth rate crawl, so at least there is some indication of improvement.

References

Standard and Poor. Dividend Action Report. [Excel spreadsheet]. Accessed 7 May 2013.

Playing the S&P 500's Wild Cards

Over the past several weeks, we've identified three potential wild cards that could affect stock prices in a positive way in the margin of our favorite chart:

• The Fed could amp up its latest QE program.


• Investors might shift their focus to 2014-Q1 in setting stock prices.


• "Noise" events.

In just the last week, we've seen evidence that all three of these wild card factors may be coming into play. Let's take them on in reverse order:

What we call a "noise event" is the stock market's response to speculative factors, which are most often associated with new information becoming known to investors. Things like jobs reports, economic data releases, and even political events are all things that can and do affect stock prices on top of the signal sent by the main driver of stock prices: the sustainable portion of expected future earnings (a.k.a. dividends). Noise is always present in the stock market, but the extent to which it present can vary greatly over time, and one of its main characteristics of a noise or news-driven event is that the response of investors to it will end. It is only ever a question of when.

The apparent surge of stock prices on Friday, 3 May 2013 in response to a better-than-expected U.S. employment situation report would qualify as a noise event. Reuters reports:

The Dow and S&P 500 advanced to all-time closing highs on Friday, with major indexes jumping 1 percent after an unexpectedly strong April jobs report eased concerns about an economic slowdown.

But what if there is something more fundamental underlying the stock market's Friday rally?

One thing we've demonstrated repeatedly since our 2008 anniversary post is that the change in the rate of growth of stock prices, measured as the 20-day moving average of daily closing values of the S&P 500 (or more simply, the monthly average of the S&P 500), tends to closely pace the change in the rate of growth of the index' dividends per share expected in the specific future quarters to which investors have focused their forward-looking attention in setting today's stock prices.

Side Note: Yes, we know sentences like this are difficult to parse. It's an unavoidable side effect that comes from our living here at present, which we do for the tax advantages, but spending much of our time otherwise working in the future. As you can imagine, commuting is a problem and at some point, we'll likely make a permanent move to be closer to work. In the meantime, if it helps decipher what we're getting at, stock prices have quantum characteristics, with changes in the rate of growth of stock prices periodically jumping from one discrete "energy level" to another, somewhat like an electron might in a hydrogen atom, but with those energy levels defined by the change in the rate of growth of future dividends per share expected in discrete future quarters.

In this case, investors could be shifting their forward-looking attention toward the first quarter of 2014, which we would observe as a transition from closely paralleling the level of change in the growth rate of the S&P 500's dividends per share for the second quarter of 2013 (where investors have been focused since 20 December 2012) to the expected level of change in the growth rate of dividends per share expected in 2014-Q1:

The upside of that kind of shift would be that stock prices would continue rising for an extended period of time. However, that change would also present a large negative risk for investors, as any shift in investor focus to a less distant future quarter would coincide with a massive crash in stock prices. Not even having the U.S. Federal Reserve seriously amp up its quantitative easing programs to offset the impact of a crash would be capable of preventing that outcome.

Speaking of which, the Fed officially opened the door to seriously amping up its quantitative easing programs last week, as documented by the WSJ's brand new Fed Statement Tracker application (HT: Barry Ritholtz):

Since the Fed actually hasn't done anything yet to increase its purchases of U.S. Treasuries above its current rate of $40 billion per month, which is what would be necessary to significantly affect the outlook for stock prices, any positive market reaction to this news would actually represent a noise event.

So that's where we stand going into this Monday, 6 May 2013. We'll find out soon just how much noise has gotten into the stock market!