Equity investors faced wild market swings in 2022. On more than 52% of the year’s days, the S&P 500 Index produced gains or losses of +/-1%. This was the highest rate since 2008 and the second-highest since the 1950s.1
High inflation, rising rates, increased geopolitical tensions, and weakening growth drove returns on the market’s down days. Hope drove the upside. Hope that inflation would soon slow, that the Federal Reserve (Fed) would pivot from its aggressive rate hikes, and that a strong labor market would dampen recessionary spirits in economic and fundamental data.
Hope is a good thing, but it isn’t a strategy. In this environment, while defensive positioning may be a better approach, it ignores the inevitability of an inflection point. The Fed can’t hike rates forever. Eventually earnings cynicism will find a bottom and optimism will be repriced. In the meantime, positioning portfolios for the fundamental weakness washing over the world, while acknowledging the potential for future positivity, takes combining offense with defense.
Dividend-paying firms support that mix.
Defensively, dividend payers have a consistent track record of returning value to shareholders but aren’t overly allocated to defensive market segments. And, they typically have a strong relationship to the value factor — a pro-cyclical exposure. As a result, dividend-focused strategies may help investors cautiously position for a cyclical recovery, without needing to pinpoint the timing of the pivot.
While inflation has declined from its peak, it’s still at a four-decade high. Consumer inflation expectations also remain near 40-year highs.2 While aggressive Fed policy has led to some improvement, defeating inflation will take some time. In the early 1980s when CPI was this elevated, it took 15 months for inflation to stabilize below 3%.
History shows, however, that dividend stocks thrive in prolonged inflation-driven markets. Since 1948 — including three periods of high inflation in the 1950s, 1970s, and 1980s — high-dividend stocks significantly outperformed their low-dividend peers and the broader market when 12-month average CPI inflation was in the top two quintiles (above 3.25%). See the following chart.
Dividend Stocks Outperform When Inflation Is High
With high inflation placing downward pressure on profit margins and monetary tightening squeezing aggregated demand, negative earnings revisions have picked up for 2023. The bottom-up consensus earnings per share (EPS) estimates for 2023 have been cut by 7% to $233 since their June 2022 peak, compared to a historical average decline of 3% in the quarter leading into a new year.3 And with leading economic indicators falling deeper into negative territory — flashing warning signs of a recession —additional earnings downgrades are highly likely.
Despite these growth headwinds and downside revisions, more than 90% of firms report they plan to keep or increase their dividend.4 In fact, the median decline in dividends paid by S&P 500 companies in the past 12 US recessions since World War II was just 1%. And there was no decline in four of those recessions when inflation was above 5%, in 1974, 1980, 1981, and 1990.5
Given that dividend payments are more stable than stock price movements – providing an income cushion for total return — dividend strategies have had reduced drawdowns and lower volatility during bear markets, on average. In the 13 bear markets since 1960, high dividend stocks outperformed low dividend paying firms, as well as the broad market by an average of 12% and 8%, respectively.6
In fact, high dividend equities have demonstrated consistent outperformance, as they outpaced low dividend paying firms and the broader market in 11 of those 13 bear markets, as shown in the following chart.
Dividend Stocks Outperform During Bear Markets
High dividend stocks underperformed only twice — during the Global Financial Crisis (GFC) and the COVID-19 pandemic — when the respective impairment of the banking system and the public health system caused many companies to cut or suspend their dividends.
Unlike those two periods, our current economic downturn is driven by typical slowing of aggregated demand on the back of monetary tightening. And so far, dividend stocks have shown similar resiliency to what we saw during most other bear markets, outperforming the broad market by 16% year to date.7
While central banks will continue to tighten until inflation is under control, disinflationary forces have started to emerge as the tightening has begun to transmit to the broader economy. The ISM PMI Price Index indicated decreasing prices for the first time since May 2020.8 Global supply chain pressures are back in line with historical levels.9 Wage inflation has fallen to its lowest level in one year,10 and rent increases have slowed.11
Disinflationary, however, is not deflationary. It just means declining inflation.
After all, our current headline inflation figure is still above historical levels, even if it is slowly declining. Yet, at some point, these disinflationary forces will accelerate and translate to persistent downward trends in consumer prices. At that point, central banks will shift their focus to growth worries and begin easing.
A policy pivot could potentially renew sentiment toward more cyclical segments of the market and usher in hope for earnings positivity off a very cynical base. But the timing is uncertain. While a pivot is getting closer, as the Fed enters the later stages of its hiking cycle and earnings continue to be revised lower, the change in trend is unlikely to occur right away.
Dividend strategies can serve as a bridge to move portfolios smoothly from a defensive stance to a more hopeful environment.
While slightly more defensive than the broader market, they are less defensive (and more offensive) than low volatility strategies, as shown in the following chart. This has led to more upside capture by dividend yield strategies over the past decade versus the full-blown defensive low-volatility strategies (72% vs. 56%).12
Dividends Play Better Offense Than Low Volatility
Despite dividend stocks’ leading performance in 2022, their attractive valuations and investors’ light positioning point to more upside potential.
After underperforming the broad market for three consecutive years, dividend stocks’ relative valuations were within the bottom decile over the past two decades based on price-to-forward-earnings, price-to-book, and price-to-cash-flow ratios at the beginning of 2022.13 Even given their significant outperformance year to date, their relative valuations are well below their long-term median (31st percentile based on price/forward 1-year earnings; 25th percentile based on price/cash flow; 21st percentile based on price/book).14
Holdings indicators produced by State Street Global Markets, using aggregated and anonymized custody data of $43.7 trillion in assets,15 show that investors’ holdings of dividend stocks have declined since the GFC, as dividend stocks underperformed growth stocks for most of those years. During the pandemic, investors’ underweight in dividend stocks reached its highest level in two decades, as growth beat dividend yield exposures by 21% on an annualized basis in 2020 and 2021.16
Although investors have been rebuilding their positions in dividend stocks amid elevated market volatility, allocations increased only to the 20th percentile over the past 20 years, indicating a significant underweight by historical measures.17 If dividend stocks continue showing resilience amid elevated market volatility and economic downturns, mean reversion in investors’ allocations may further support dividends’ performance in 2023.
To take advantage of dividend payers’ unique mix of defensive and offensive characteristics as markets brace for more volatility, while remaining hopeful about the future, consider:
1 Bloomberg Finance, L.P., as of November 11, 2022.
2 University of Michigan Consumer Survey, New York Fed Survey of Consumer Expectations, as of November 11, 2022.
3 FactSet, as of November 11, 2022.
4 "Equity Market Review - Lessons from Q3 earnings and clues for 2023,", Barclays November 18, 2022.
5 Goldman Sachs, July 2022. The numbers are calculated by comparing the previous four quarters at the start of each recession with the last four quarters at the end.
6 Bear markets are defined as when the S&P 500 declined by more than 19%).
7 Dividend stocks are represented by the S&P 500 High Dividend Index, as of October 31, 2022.
8 ISM PMI, as of October 31, 2022.
9 New York Federal Reserve, Global Supply Chain Pressure Index, as of October 31, 2022.
10 US Bureau of Labor Statistics, based on average hourly earnings of all private employees, as of November 13, 2022.
11 US Rent Growth Continues to Slow in August, CoreLogic Reports.
12 FactSet, as of October 31, 2022. S&P High Yield Dividend Aristocrats Index and MSCI USA Minimum Volatility Index are used to represent dividend yield and low volatility strategies.
13 FactSet, as of November 11, 2022.
14 FactSet, as of November 11, 2022.
15 State Street Global Market, as of September 30, 2022.
16 FactSet, as of October 31, 2022. Growth is represented by the S&P 500 growth index. Dividend yield is represented by the MSCI USA High Dividend Yield Index.
17 State Street Global Markets, as of September 30, 2022.
Measures the expected move in a stock relative to movements in the overall market. A beta greater than 1.0 suggests that the stock is more volatile than the broader market, and a beta less than 1.0 indicates a stock with lower volatility.
Consumer Price Index (CPI)
A widely used measure of inflation at the consumer level that helps evaluate changes in cost of living. The CPI is composed of a basket of consumer goods and services across the economy and is calculated by the US Department of Labor by assessing price changes in the basket of goods and services and averaging them. Core CPI is the same series, but excluding food and energy prices, which are considered to be volatile enough to distort the meaning and usefulness of so-called headline CPI. The absence of food and energy, means the core series reflects long-term inflation trends more accurately.
Dividend Equity Investing
A style of investing focused on owning companies or a portfolio of companies that make distributions and, in turn, reinvesting those dividends regularly with a view to slowly accumulating wealth over the long term.
Earnings Per Share (EPS)
A profitability measure that is calculated by dividing a company’s net income by the number of shares outstanding.
Global Financial Crisis
The economic crisis that occurred from 2007-2009 that is generally considered biggest economic challenge since the Great Depression of the 1930s. The GFC was triggered largely by the sub-prime mortgage crisis that led to the collapse of systemically vital US investment banks such as Lehman Brothers. The crisis began with the collapse of two Bear Stearns hedge funds in June 2007, and the stabilization period began in late 2008 and continued until the end of 2009.
An overall increase in the price of an economy’s goods and services during a given period, translating to a loss in purchasing power per unit of currency. Inflation generally occurs when growth of the money supply outpaces growth of the economy. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.
PMI Price Index
ISM’s manufacturing index, also known as the purchasing managers' index (PMI), is a monthly indicator of US economic activity based on a survey of purchasing managers at more than 300 manufacturing firms. It is considered to be a key indicator of the state of the U.S. economy.
Price-to-Book Ratio (P/B Ratio)
A valuation metric that compares a company’s current share price against its book value, or the value of all its assets minus intangible assets and liabilities. The P/B is a ratio of investor sentiment on the value of a stock to its actual value according to the Generally Accepted Accounting Principles (GAAP). A high P/B means either that investors have overvalued the company, or that its accountants have undervalued it.
A stock-valuation measure that is calculated by dividing a firm’s cash flow per share into its current share price. Financial analysts often prefer to value stocks using cash flow rather than earnings because earnings are more easily manipulated.
Price-to-Forward Earnings Ratio
The price of a security per share at a given time divided by its projected earnings per share over the coming year. A forward P/E ratio is a way to help determine a security’s stock valuation — that is, the fair value of a stock in a perfect market. It is also a measure of expected, but not realized, growth.
S&P 500® Index
A popular benchmark for U.S. large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
Upside Capture Ratio
A statistical measure of an investment manager's overall performance in up-markets. It is used to evaluate how well an investment manager performed relative to an index during periods when that index has risen.
One of the basic elements of “style”-focused investing that focuses on companies that may be priced below intrinsic value. The most commonly used methodology to assess value is by examining price-to-book (P/B) ratios, which compare a company’s total market value with its assessed book value.
The tendency of a market index or security to jump around in price. Volatility is typically expressed as the annualized standard deviation of returns. In modern portfolio theory, securities with higher volatility are generally seen as riskier due to higher potential losses.
The views expressed in this material are the views of Michael Arone, Matthew Bartolini and Anqi Dong through the period ended November 17, 2022 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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