Could Dividends Drive the S&P 500 to 3,000?

Will dividends push the S&P 500 up to 3,000 -- roughly 50% above its current level -- before the end of the decade? That is the argument Dominic Rossi, Fidelity's global chief investment officer for equities, made in yesterday's Financial Times. It's worth taking a few minutes to deconstruct his argument to gain a better sense of what dividends can and can't do for investors.

Dividend growth is highly prizedThe thrust of Rossi's argument goes something like this:

Savings are rising faster than income in the developed nations.
Those savings are in search of yield in a yield-deprived world.
The dividend growth of U.S. equities make them by far the most attractive destination for those savings.
The resulting demand will support a low dividend yield on U.S. equities as dividends continue to grow.

So far, so good, but that is all "helicopter view" stuff. Let's look at some of the nuts and bolts of the assumptions behind the forecast:

Fifteen quarters takes us back to the first quarter of 2011, at which time dividends were depressed, having fallen by a fifth relative to their pre-financial crisis high. Still chastened by the crisis, companies in the S&P 500 were paying out in dividends a nearly all-time-low proportion of their profits. That doesn't deter Rossi, however:

I couldn't verify the figure of 32% for the payout ratio (the numbers I derive are somewhat higher), but I assume the last sentence suggests companies have room to increase this ratio from its current level, which is below its historical average.

Let's not forget buybacksHowever, if we add share buybacks to obtain a genuine capital return ratio, we find companies returned $0.95 of every dollar of profit to shareholders in the trailing 12-month period ending with the third quarter of 2014. Companies' flexibility to increase their dividend payout ratio might not be as great as Rossi suggested. But here's the crux of the forecast:

If S&P 500 dividends were to increase to $60 by 2019, that would indicate a 10-year annualized growth rate of 10.3%. The following chart, based on data compiled by Yale University economist Robert Shiller, shows the trailing-10-year growth rate in dividends for every month since January 1950.

Source: Author's calculations based on data from Robert Shiller.

The chart makes it quite clear that a 10-year growth rate in excess of 10% is exceedingly rare -- in fact, it has only occurred during a six-month period in the mid-1950s. In that light, a $60 dividend forecast looks very optimistic.

The trouble with the dividend yieldFinally, applying the dividend yield to estimated dividends five years out doesn't produce a robust forecast of the S&P 500. The dividend yield is a small number andinversely proportional to the index level, so small changes in your dividend yield assumption have a significant impact on your estimated index values.

Sure, a 2% dividend yield indicates a 3,000 forecast for the S&P 500 ($60/ .02 = $3,000), but is it hard to imagine a dividend yield at 2.25% instead? The latter puts the S&P 500 at 2,400 -- hardly a disaster, but a far cry from Rossi's rosy forecast. I'll let you calculate the implications if the dividend yield were to return to its 65 - year average of 3.3%.

I'm not foolish enough to assert the S&P 500 can't reach 3,000 by the end of 2019, but I think it's unlikely; either way, I don't find Rossi's argument convincing -- at least insofar as his numbers are concerned. On the other hand, he might be onto something with the notion that shares that offer a reliable stream of growing dividends will command a premium over the broad market for the foreseeable future.

The article Could Dividends Drive the S&P 500 to 3,000? originally appeared on Fool.com.

Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool owns shares of Bank of America and owns and recommends shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.