The Power of Dividends in Declining Markets

By TradeSmith Research Team

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Well, the first three quarters of 2022 are in the books. And the third quarter, which ended in September, didn’t look much better than the first half of this year for both stocks and bonds.

To recap, the S&P 500 Index declined 5.3% last quarter and is down nearly 22% since the start of the year. But if you think that’s bad, just look at bond returns.

U.S. 20+ year Treasury bonds dropped another 10.8% last quarter and have now plunged 30.9% year to date. So much for the “safe haven” status and diversification benefits expected of bonds.

To be sure, stock investors have been roughed up this year, especially growth stock investors. But fixed-income investors have taken a far worse beating.

When one-year Treasury notes yield 4.15%, who in their right mind wants to own 20-year Treasury bonds that yield even less, only 3.95%?

Recently, financial pundits have tried to apply the same argument to stocks, as the S&P 500’s dividend yield of 1.69% is less than half the current yield on one-year Treasury notes. So why buy dividend-paying stocks?

I’ll tell you exactly why.

Because dividends aren’t static like the fixed yield on Treasuries. Dividend payouts from quality companies tend to grow over time. That makes your yield a few years from now potentially much greater than the current yield.

And dividends are the only thing that’s “working” in the stock market right now to save investors from even steeper losses.

Growth stocks, as measured by the SPDR Portfolio S&P 500 Growth ETF (SPYG), are down nearly 30% year to date.

Value stocks, as measured by the SPDR Portfolio S&P 500 Value ETF (SPYV), are down less than 15% so far this year, or just half as much as growth. Plus, value stocks often pay healthy, growing dividends.

And these percentages capture price returns only. High-dividend-yielding stocks also would have paid you cash dividend income to help offset some of the downside in 2022.

Quality, low-risk, dividend-paying stocks are the place to be right now, as you can see in the chart above. It’s the sweet spot for investors in difficult markets.

In today’s climate of slowing growth, rising inflation, and higher interest rates, our economy is surely in what economists call the “late cycle” phase (Phase 3 on the chart). And as you can see above, the best-performing stocks by far are high-quality, low-risk, and high-dividend-yielding stocks.

Dividends have made up about 40% of the stock market’s total return since the 1930s. And dividends accounted for over 70% of market returns during the 1970s, when inflation was as high as it is today.

This clearly shows that dividend-paying stocks have bona fide inflation-resistant credentials.

That’s because dividend payouts often rise along with inflation. And stocks that consistently boost their dividends during inflationary times most often outperform the stock market.

Dividend-paying stocks are also somewhat recession-resistant, able to outperform in difficult downtrending markets like we have right now. For example, during the 1930s and again during the 2000s, dividends almost completely offset the decline in stock prices.

But be careful about how much dividend yield you reach for with your stock selection.

A very high yield may look attractive, but it could be a red flag that the dividend payout is unsustainably high.

It could also be an indication that the company paying the dividend is in financial distress. If so, the dividend could easily be reduced or eliminated altogether.

As the chart above from Fidelity shows, stocks with medium-high dividend yields tend to beat the market with the best risk-adjusted returns, while stocks with very high yields (in the top 10%) or very low yields often underperform.

For my Dividends on Demand subscribers, I use the Screener tool to search for stocks in the sweet spot of dividend yield, which today is roughly between 2% and 7%.

Of course, these stocks must also be in our Health Indicator Green Zone and in an uptrend or side-trend.

Finally, I also filter out stocks with low or nonexistent free cash flow.

I ran this screen this week as I always do and came up with a list of 26 quality, blue-chip stocks with dividend yields that are well above average but not too high. Here are some of the standouts:

  • Amgen Inc. (AMGN), a biotech blue chip with a 3.37% dividend yield.
  • ConAgra Brands Inc. (CAG), a defensive consumer staples company with a 4.01% yield.
  • Campbell Soup Co. (CPB), an iconic defensive blue chip with a 3.1% yield.
All are perfect examples of the kind of stock you want to seek out in today’s difficult market environment: quality, consistent, undervalued dividend payers.