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September 19, 2005 |
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From March 2000-October 2002 many analysts claimed that scared ‘new economy’ investors were seeking refuge in dividend paying companies, and that falling US interest rates made stocks more attractive compared to bonds. These optimistic analysts – Cohen and Kudlow to name two – eventually got it right when stocks turned higher in 2003. Nevertheless, the statistics clearly show that during the 2000-2002 bear market the average dividend yield on the S&P 500 was on the rise, and that even declining US interest rates failed to support stock prices.
A more detailed example of the dividend trend during the bear market is seen when comparing REIT yields to that of the 10-year Treasury yield. To reiterate: the combination of rising (REIT) yields and a falling 10-year yield did not entice investors into dividend investments during the bear years (highlighted in red).
Suffice to say, it is easy to label bullish interest rate/dividend stories told during the 2000-2002 bear market as being little more wishful thinking (while investor interest in dividend paying companies may have been greater than in say internet stocks during the bear market, that almost all stocks, including those paying a dividend, declined is hardly worth cheering). However, in 2003 when the bear market went into hibernation and dividends quickly became the rage, the bullish theories touted by Kudlow, Cohen, and others during the bear market suddenly seemed prophetic. Indeed, with Bush’s dividend tax cut (May 2003), Fed rate cuts essentially taxing savers, and the bear market having reduced investor expectations, owning anything offering a dividend made almost perfect sense... The word ‘almost’ is in italics because at some point from 2003-today healthy speculation in dividend paying companies turned into a dangerous hunt for yield. Nowhere is this threat more apparent than in REITs, which in less than 3-years went from being shunned to adored by the investing public.
In light of these illustrations, the conclusion is that dividend yields rise as stock prices fall and dividend yields decline as stock prices rise. While there are certainly exceptions to this rule, history deems it as usually accurate. The Hunt For Potential Dividend Investments Along with countless stock search engines and Mergent’s dividend achievers, Standard and Poor’s new index, the ‘dividend aristocrats’, helps the investor scan the dividend elite. The index, which tracks S&P 500 components that have increased dividends in each of the last 25-years, currently has 56 components. Studying these companies and their competitors is a good place for the dividend hungry investor to start (Basic Table ~ Download Index Statistics). Unfortunately, after an a analysis of the dividend aristocrats no solid dividend opportunity emerges. Rather, as a group overvaluation issues emanate. To begin with, that for every insider purchase made during the last 6-months there has been 73 insider sales (measured by volume), is not encouraging. Less encouraging still is that many of the companies that traditionally produce stable results when the economy is weak (KO, PEP, JNJ) currently do not have attractive yields. Thus, if the long-term investor wants to find comfort in a quality company like BUD, they should do so with a dollar cost average approach backed by the understanding that yield alone may not be enough to support the company’s stock price when the bear returns. The low and declining yields (compared to the 10-year) on traditionally defensive and slow growth stocks could be a signal money is on the move into recession resistant stocks. This theory jives with the fact that financial stocks (BAC) - which typically do not perform well late in the business cycle - have some of the highest yields in the group. Rising yields in financial stocks, which are the result of strong earnings results and flat stock prices, and falling yields in recessions stocks are signals that the US economy is extremely deep into its recovery (or that at least investors think so). More Late Cycle Signals As if the flattening US yield curve, choppy economic reports, crazy gains in asset (home) prices, and high yields/flat stock prices in financial stocks were not enough, the action in the markets in 2005 also suggests that we are late in the business cycle. To be sure, energy, utilities, and health care are dividend intensive industries that tend to thrive late in the business cycle. These three industries have been leading the markets this year.
The optimists argue that financial stocks may not be done running yet - that in 3Q05 financial stock earnings are expected to be up by more than 25% (First Call)! What is worth pointing out is that the expected earnings surge in financial stocks is largely due to favorable year-over-year comparisons. Sequentially financial stock earnings are expected to be down in 3Q05. Conclusions With Mergent, S&P, and stock scanners like MSN at the average investor’s disposal, finding a quality dividend paying company is easy to do (Mergent’s list ~ Excel). But alas, with the average S&P 500 dividend yield less than 2%, serious study of any dividend list borders on pointless: the energy spent discovering that Automatic Data Processing is an extremely solid dividend payer is energy that is probably better spent pondering Krispy Kreme’s investment potential or the state of the South African mining sector. In short, finding quality dividend companies is easy, but finding a quality dividend company that is attractively priced this late in the business cycle is exceptionally challenging. The term ‘business cycle’ remains an important consideration for the dividend investors because unless foreign investors suddenly stop buying dollars and/or US interest rates skyrocket, the likely culprit behind the next broad increase in dividend yields will be a stock market decline (in response or in anticipation of an economic/earnings recession). Remember, dividend yields rise as stock prices fall and dividend yields decline as stock prices rise: At the height of the 2002 bear market the average REIT investor demanded a 4.5 percent point premium to own risky REITs instead of safe bonds (10Year). As recently as August 2005 this gap slipped to below 0.4%. In other words, REIT yields were recently being regarded as almost as reliable as the yield on the 10-year treasury bond. Whether you care to compare dividend yields to bond yields, track and speculate on payout ratio trends, or focus on hot sector trends (i.e. Energy), today’s historically low dividend yields are just that. During the 2000-2002 bear market dividend yields rose even as US interest rates declined. Don’t be surprised if during the next downturn in stocks dividend yields rise regardless of what US interest rates do. Dividend Models ~ Excel Files Dividend Policy Analysis: http://www.stern.nyu.edu/~adamodar/pc/dividends.xls Complete dividend discount model: http://www.stern.nyu.edu/~adamodar/pc/divginzu.xls Stable growth, dividend discount model: http://www.stern.nyu.edu/~adamodar/pc/ddmst.xls BWillett@fallstreet.com |
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