The economy is gradually recovering from its pandemic-related slowdown, and inflation has hit its highest rate in 30 years. That combination may make this an especially good time to consider investing in stocks that pay dividends. The appetite for high flying technology companies and the volatility that go with them has somewhat soured for now, as investors long for the stability of stock prices and companies that make regularly scheduled dividend payments. Dividends have historically been the backbone of stock market returns during inflationary periods. Market data tells us that dividend payments have accounted for approximately 40% of the overall stock market’s return since 1930. What’s even more interesting is that dividends can help increase returns when the market has down periods. According to Fidelity Research, stock prices in the S&P 500 fell during the 1930s and 2000s, but dividends almost completely offset the decline. In the 1940s and 1970s, when inflation surged, dividends accounted for 65% and 71% of the S&P 500’s return, respectively. Remember that like yield is to bond returns, as the price of a stock goes down, its dividend yield will rise.
It may seem counterintuitive that generating cash through dividends while inflation is rising and devaluing each dollar is the way to go. However, there are some financial points worth noting. As the data above suggests, blue chip companies typically pay out interest rates via dividends that are higher than the inflation rate. S&P 500 companies like Chevron pays a current dividend of 3.8% and has seen its share price rise by some 18% this year, totally outpacing inflation. According to Sandy Villere, a portfolio manager at wealth management firm Villere & Co., which manages $2.4 billion in equity and fixed-income strategies, “In this environment, a good place to hide would be some of these dividend-oriented companies that are going to grind through this market turbulence.”
NASDAQ data suggests that Dividend payout ratios tend to be stable during key inflationary periods. Dividends also exhibit less volatility than stock prices and earnings. Also, high dividend yielding stocks outpace inflation over the long-term. Even in cases where inflation might seem to bury them for a few months, or even years, the high-yield stock will often win out in the long run.
The S&P 500 and the Nasdaq Composite suffered through their worst January in more than a decade as big tech stocks slid. The indexes are down 5.9% and 10%, respectively, this year, while the Dow Jones Industrial Average is down 3.4%. So why does the NASDAQ fall harder than the other exchanges? It’s the economy, stupid. In general, growth or tech companies have lower earnings, if earnings at all, than there blue chip brethren. Thus, growth is financed largely through borrowing, and as interest rates and inflation rises, so does the cost of financing such growth. Therefore, when valuing stocks using the discounted cash flow method, in times of rising interest rates, growth stocks are negatively impacted far more than value stocks. This suggests a positive correlation between inflation and the return on value stocks and a negative one for growth stocks.
One must be careful though as all dividend stocks are not created equal. Remember that dividends in general are a by-product of earnings, thus it is important to understand the financial health of the underlying security. So here’s the thing. Dividends are not guaranteed. They can be reduced or even more draconian, eliminated entirely, depending on the profits and health of the company. Anyone who owns GE stock experienced this reality in the fall of 2018 when, in the wake of financial troubles, the company cut its quarterly dividend by 92% to just one cent per share. And even further back, in 2008, major banks slashed or eliminated their dividends during the Great Recession. This doesn’t make dividends necessarily bad for your portfolio, but diversification among issuers is needed. As of this writing, here are the top 10 high dividend stocks in the U.S.
If you have the means to invest in a basket of equities to diversify your portfolio, a rule of thumb is to not invest more than 10% of your portfolio in one individual stock and no more than 20% in one sector. If you want to get into the dividend game, but don’t have a ton of capital, dividend generating ETF’s might be your answer. Because inflation can hit different sectors in different ways, it is important to have a wide diet of dividend producing products in a portfolio. The following is a list of the 10 largest dividend ETF’s by AUM.
The rotation has begun. People invested some $7.5 billion into dividend paying stocks and ETF’s this past January alone. One would imagine that as commodity prices are rising, particularly oil and gas which can be bellwether sings of inflation to come, this rotation may just be beginning. High commodity prices often squeeze corporate profits, which in turn reduces stock returns. Therefore, following the commodity markets may provide insight into future inflation rates. The rotations are like our seasons, they come and go and can be predictable. As they say, what comes around goes around.
