Dividend Stocks Favored in Sideways Market

Posted by Eric Anderson on January 19, 2012

eric_f.jpegThe fears of the widening European debt crisis / Euro currency melt-down that were so pronounced during the 3rd quarter started to ease early in the 4th quarter, as specific details about ways to deal with the situation emerged.  As a result, stocks were able to erase a 19% year-to-date pullback during the fourth quarter, and ended the year basically unchanged.  The weakest total return equity results were experienced by international equities, with the MSCI EAFE declining by 11.7%, while the Russell 2000 small cap index lost 4.2%.  Large caps delivered stronger results, as the S&P 500 rose by 2.1%,  while the NASDAQ slipped -0.8%, and the Dow Jones Industrial Average posted the strongest results of +8.4%.

A fair amount of the strength of the Dow’s performance can be traced to investors flocking to stocks with attractive dividends during 2011, continuing a trend that we have been out in front of for some time now, namely looking for strong and recurring cash flows from the dividends of well managed companies.  It is interesting to note that as recently as 2007, a risk adverse strategy of  $100,000 invested in six month C.D.s could generate $5,240 of annual income, but today that has collapsed to just $419.  Slowly but surely, this has led investors and retirees looking for income to consider equities, which for some was an asset class that they had given up on years ago.  This phenomenon is confirmed when examining the S&P 500 sector performance which showed that three of the four sectors with the highest dividend levels delivered the strongest overall results in 2011.  Specifically, Utilities returned 20%, with Consumer Staples at 14%, and Telecommunications and Consumer Discretionary delivered 6.3% and 6.2% respectively last year.

Except for the strong rebound years of 2003 and 2009, in each year since 2000, the total return for dividend paying stocks has exceeded those of non dividend paying stocks.  While dividend stocks do lag non dividend paying stocks in strong up years, they tend to more than make up for this over time by not declining as much in big down years.  Standard & Poor’s published a study last year which showed that if an investor had purchased $10,000 of dividend paying stocks in 1979, and reinvested the dividends, the $10,000 would have grown to be worth $416,600 by the end of 2010. 

As was the case last year at this time and, as we begin 2012, debate again is swirling around whether stocks or bonds will offer the superior return this year.  2011 began with historically low current yields, which went even lower as the year progressed, and as a result bonds outperformed stocks.  However, the valuations of bonds today are like stocks were in the late 1990’s – expensive.  As we saw over the course of 2011, expensive can stay that way for a while or get even more expensive.  But looking a little deeper at the valuation metrics, stocks do appear to be cheap, especially on a relative asset class basis.  Specifically, it is interesting to note the difference in valuations between stocks and bonds starting from when the equity market peaked in March of 2000, compared to yearend 2011.  Back in March of 2000, the S&P 500 was trading at 25.5 times earnings and had a 1.1% dividend yield, versus today’s 11.8 times earnings level and a 2.1% dividend yield.  Over this same time frame, the 10 year Treasury was yielding 6.2% versus 1.9% at yearend.  Additionally, the level of cash on corporate balance sheets as a percentage of their current assets has almost doubled to 29% from 14% over the same time period.  Looking at a slightly long 15 year time horizon, a few additional valuation statistics confirm the attractiveness of equities.  They are: the S&P 500’s current multiple of its price dividend by its book value and its cash flow multiple of 2.1 and 8.2 times respectively, versus the 5, 10 and 15 year averages of 2.3, 2.6, and 3.1 times for its price to book, and 8.6, 10, and 11.1 times for its price to cash flow multiple.

Only three of the ten S& P 500 sectors: Materials, Industrials, and Financials delivered negative returns in 2011, with the weakest results -17% for the year from the Financial group which continues to work through the effects and excesses of the past credit cycle.  While the S&P 500 is still 11.8% lower than its peak pre-housing-and-credit-crunch level in October 2007, half of its ten sectors are now higher than their prior peak.  But the weakest group, which should not come as a surprise, is the Financial group, still at 60% below its 2007 peaks.  The sectors that have more than recovered their prior losses and are now higher than they were in Oct. 2007 include Technology, Healthcare, Consumer Staples, Consumer Cyclical, and Utilities.
Stocks around the world have continued to trade largely as a group, with weakness or strength in one market often spreading across the globe.  The markets appear to be even more interconnected when one also factors in how currency and commodity trading can affect stocks.  We have witnessed for quite some time how there is an almost coordinated move by investors / traders of either a “risk on” or “risk off” trading session.  As a consequence, market volatility has spiked to elevated levels, with numerous days back in August which saw stocks declining or advancing by more than 4% in a single trading session.  The year ended with an average volatility level for the Dow Jones of 1.17% (the index up or down by that much per trading day) compared with its long term average since 1926 of 0.72%, and the elevated 3.3% level in 2008.  However, while on the topic of volatility, it bears mentioning that J.P. Morgan published a recent study that shows that since 1980, despite an average intra-year decline of 14.3%, that the S&P 500 has delivered a positive annual return 77% of the time (24 of the 31 years in the study period), which suggests that one should try very hard not to let market volatility chase you out of your investment plan.