Blackstone’s Got An Old-School Model And Here’s What It Says About Buying The Dip

Blackstone’s Got An Old-School Model And Here’s What It Says About Buying The Dip
Russell Burns

10 months ago5 mins

  • The dividend discount model calculates an implied fair value based on earnings estimates and the US 10-year yield.

  • As long as inflation remains under control, buying the dip is likely to remain a sensible investment strategy – especially since valuations are more sensitive to interest rates than earnings.

  • Identifying alpha opportunities is going to be more important to returns than beta in the upcoming years, Blackstone says, since you can no longer expect expanding multiples to drive stock market returns.

The dividend discount model calculates an implied fair value based on earnings estimates and the US 10-year yield.

As long as inflation remains under control, buying the dip is likely to remain a sensible investment strategy – especially since valuations are more sensitive to interest rates than earnings.

Identifying alpha opportunities is going to be more important to returns than beta in the upcoming years, Blackstone says, since you can no longer expect expanding multiples to drive stock market returns.

Mentioned in story

Blackstone’s quarterly outlook often provides some interesting insights into the stock market and this time around, two things really jumped off the page. The first is how the investment house is using the dividend discount model to weigh stock valuations. The other is what Blackstone sees as the rising importance of identifying “alpha” opportunities in stocks. And they both might give you more confidence about buying future dips.

What is the dividend discount model?

Tucked in among Blackstone’s report is a slide that shows the implied fair value for the S&P 500, calculated using the dividend discount model (DDM). Byron Wien, vice chairman of Blackstone’s Private Wealth Solutions and overall pretty smart guy, created the model back in the 1980s when he worked at Morgan Stanley. He uses it as a guide to help figure out whether the stock market is trading cheap or expensive at any given time.

The S&P 500’s implied fair value level, according to the dividend discount model. Source: Blackstone.
The S&P 500’s implied fair value level, according to the dividend discount model. Source: Blackstone.

The model uses two key variables: the US 10-year Treasury yield and the earnings-per-share (EPS) estimates for S&P 500 index. And the premise is this: if you know where the US Treasury 10-year bond yield is trading and what the earnings estimates are for the S&P 500 index, you can calculate the implied fair value for the S&P 500. (If you want to dive into the math behind the formula, you can find it here.)

Right now, the US 10-year Treasury bond yield is around 3.51% and the consensus 2022 EPS estimates for the S&P 500 is $220. Using the DDM table above, you can see that the implied level for the S&P 500 is around 3,700, so at the current level of roughly 4,100, the market looks pretty overvalued based on this model.

What's the opportunity here?

The key takeaway from this chart is that the fair value of the S&P 500 is actually more sensitive to changes in the 10-year yield than it is to earnings estimates. The two variables are, to some extent, interdependent, so when one changes, the other will likely do so too. For example, if earnings estimates slide, then the 10-year bond yield will also likely decline as markets start to factor in the possibility of an economic slowdown. But what this chart really does is help illustrate how bad news about the economy ends up actually being good news for the stock market.

If, for example, earnings drop to, say, $200, and that coincides with a fall in the 10-year US yield to 3.1% (i.e. a move to the left on the chart), the indicated fair value for the S&P 500 becomes 4,293, higher than today’s level. So, an earnings shortfall doesn’t necessarily suggest a fall for the S&P 500.

This dynamic is likely to hold as long as inflation pressures remain under control – and more recently that seems to be happening. And if the model’s to be believed, it suggests you can have more confidence in buying the dip in the stock market.

Of course, there are drawbacks to any model used to determine the fair value of stocks, and this one’s got its faults. The major one is it looks only at dividends paid, and a lot of the companies, in fact, some of the biggest companies, like Facebook and Alphabet, don’t pay dividends. No model is perfect.

Now, Blackstone thinks the consensus 2023 EPS $220 estimate for this year is too high. But being forward-looking – always good when investing – the current 2024 EPS estimate for the S&P 500 is $240. If that proves to be accurate, then (using the table above) you’ll see the implied fair value for the S&P 500 is 4,036, roughly where the S&P 500 is trading now.

And if behemoth investing institutions like Blackstone are using models like the DDM to decide on equity or bond allocations, you might reasonably have confidence in buying the SPDR S&P 500 ETF (ticker: SPY; expense ratio: 0.095%) or Invesco QQQ Trust (QQQ; 0.2%) on any dips. Indeed, it may even be worthwhile keeping a copy of the DDM table handy to help understand market levels.

Why is alpha now more important than beta?

Beta – in other words, the market just going up – isn’t driving outsized returns the way it used to. And probably won’t, at least not for a while. So Blackstone’s experts are warning that finding alpha stocks – ones that create their own rallies – is going to be essential. That means identifying profit growth opportunities, having higher conviction positioning, and looking for companies with strong cash flow creation and the ability to grow that cash flow.

While annual stock returns over the past decade have been in the region of 10% to 20%, Blackstone reckons that in the coming years, stock returns are set to return only 5% to 10%. Its experts cite three key reasons for this: they say margins will be lower; inflation pressures will shrink but not disappear; and interest rates will remain higher than they used to be.

See, from March 2009 until January 2022, 40% of the S&P 500’s return was a result of multiples expansion, which itself was boosted by central bank balance sheet expansion. In other words, as central banks embarked on massive bond-buying programs, known as quantitative easing, they kept interest rates uber-low, inspiring a strong and prolonged rally for stocks. Now, with little reason to think there’ll be a central bank balance sheet expansion or substantially lower interest rates any time soon, Blackstone now sees it as pretty improbable that valuation multiples will expand from current levels.

What’s the opportunity here?

While stock returns of 5% to 10% sound fairly reasonable (though not stellar), they might also give you some confidence to buy the dip if and when the market declines. With profit growth a likely driver of future stock returns, you might want to consider looking East, where Chinese growth is recovering. The iShares MSCI Emerging Markets ETF (EEM; 0.69%) or iShares MSCI China ETF (MCHI; 0.58%) can help you give your portfolio exposure to Chinese stocks.

Closer to home, you could look for stocks that generate steady cash flow, even when growth is harder to come by: they’re likely to outperform in that kind of environment. The Pacer US Cash Cows 100 ETF (COWZ; 0.49%), which invests in large-cap and mid-cap US companies with high free cash flow yields, may fit the bill there.

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