I remember a brokerage house strategist(from Lehman?) making a sales call in 1984 on the money management firm I was working for. The main point of his presentation was his belief that there was tremendous predictive value in the level of the dividend yield on the S&P 500 index. According to the strategist, the dividend yield on the S&P rarely fell below 3%. It never stayed that low. Therefore, the dividend yield on the index falling below 3% was the strongest possible sell signal that stocks could give.
As it so happened, the yield had just dipped below the fateful 3% line. So the strategist’s strongly held conviction was that clients should reduce exposure to the stock market, and should rotate any holdings that remained into a very defensive posture.
Three years later, the index had doubled–and the strategist was out of a job.
Where did he go wrong?
Admittedly, hindsight makes it easier to see, but he missed just about all the important economic influences in play during the period. Specifically:
–the decade of the 1980s saw great structural economic change in the US, including the emergence of women in the workforce, the widespread move of families to the suburbs, the rise of specialty retailing as competition for department stores, and the change from the mainframe to the PC. Companies were also expanding rapidly abroad.
The result of all this was that most firms were reinvesting all their cash flow into growing their businesses. They didn’t want to raise dividends. In some cases, it would have been a condition of getting new bank loans that they not do so.
–the emergence of discount brokers, along with the move to self-directed 401ks and IRAs, made equity investing accessible to young Baby Boomers who were much more interested in making capital gains than earning income. We didn’t want income.
–interest rates were in the early days of a quarter-century decline. This secular movement made capital gains easier to achieve, and current income worth less. (Of course, during the accelerating inflation period of the late 1970s, investors of all stripes actively shunned dividend stocks.)
Other than for a short period in early 2009, when the dividend yield on the S&P reached 4%–and, by the way, gave a strong “buy” signal in doing so–the yield on the index hasn’t spent any significant time above 3% since 1984.
The dividend yield on the S&P is currently about 2.1%.
Economic conditions also changed substantially since that day in 1984. In particular,
–the dramatic positive effect on the US of the entrance of women into the labor force has passed, as have the boosts caused by changes in retail and the development of the suburbs. As a result the trend growth rate of the economy has slowed (from 3%+ to maybe 2.5%); consequently, reinvestment demand for corporate cash has waned.
–many of the iconic firms of the Eighties and Nineties have matured (MSFT is the poster child for this phenomenon) and are generating tons of excess cash.
–the Baby Boom is starting to retire and is less interested in investing for capital gains than to receive steady income.
–at the moment, short-term interest rates are at the emergency low rate of essentially zero vs. what the Fed thinks should normally be around 4.5%. This is to help the economy heal itself of the wounds caused by twelve years of policy blunders in Washington, widespread regulatory failure and fraud perpetrated by major domestic financial companies. So income investors can’t achieve their goals by buying government bonds or money market funds.
dividend stocks as underperformers
Stocks whose attraction is solely, or mostly, their ability to pay steady or rising dividends to shareholders have been chronic market underperformers throughout the thirty + years I’ve been involved in the stock market.
But changes in investor preferences, combined with the lack of higher-yielding fixed income alternatives and the increasing propensity of publicly traded companies to pay dividends, have caused a mini-renaissance in dividend stocks over the past couple of years. Yes, dividend stocks have still been underperformers during the market bounceback that began in March 2009. But not so much recently. And, as they usually are, dividend stocks had been substantial outperformers during the market decline of 2007-2008. So the fact that they lagged in the early part of the current cycle is understandable.
where we are today
According to the most recent Factset Dividend Quarterly:
–400 of the S&P 500 constituents are now paying dividends, the highest percentage since before the Internet bubble burst
–growth in dividend payments is outpacing growth in S&P 500 earnings
–the S&P payout ratio (the percentage of after-tax earnings devoted to dividends) remains at 28.0%, about 10% below what has been typical over the past ten years
–the valuation of dividend-paying stocks vs. their non-dividend counterparts appears to be stretched.
The raw data on this last point are stunning. According to Factset, the PE of dividend-paying stocks is now 244 basis points lower than the PE of non-dividend stocks. If we take monthly readings of this statistic over the past twenty years, the median discount is 1304 basis points. So it would appear on the surface that the multiple on dividend stocks has expanded by over a thousand basis points vs. non-dividend stocks. …uh oh. …run?!?
That number is misleading, though. In rough terms, the 1160 point spread would probably be cut in half if we factor out the crazy valuations applied to so-called TMT (tech, media, telecom–mostly non-dividend) stocks during the Internet bubble. We might clip off another 100 bp or so if we adjusted for the fact that many companies have changed stripes away from non-dividend to dividend payer over the period we are considering.
Even so, there has been a substantial upward readjustment of the relative valuation of dividend-paying stocks in the US market over the past couple of years.
Is there anything left to go for? or is the dividend stock phenomenon all played out?
That’s my topic for tomorrow.