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More Love for Dividends and More Evidence for Patience

| January 16, 2023
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We’re in 2023’s infancy, and as we said last week, a change in the calendar doesn’t mean the investing environment or strategy changes. As CFS clients and blog readers know, we have a philosophy of believing in the power of dividends. No matter the market conditions, we love dividends, especially when markets are rocky like we’ve seen for the past year and will probably continue to see for the next six to nine months.

Dividend strength was on display last year as dividend growth strategies outperformed everything last year, posting only low, single-digit declines, comparatively. They work longer-term too, as history shows they thrive during uncertainty, just like last year.

If you’ve read our 2023 outlook, you know we think stocks will rebound later this year. But we also said it would be a bumpy ride. This is where a dividend growth strategy can outperform. Today we want to reinforce why dividend strategies will likely continue to be successful and popular.

Eighth Wonder of the World

Albert Einstein famously described compound interest as the eighth wonder of the world. He may as well have been referring to investing in dividend growth companies. Since 1930, the S&P 500 has returned 5.7% per year without dividends versus a 9.7% average annualized return when reinvested dividends are included (i.e., compound interest):

In other words, more than 40% of the market’s long-term return is dividends. If you’re not investing in dividend-paying assets, you’re missing out on compound interest. That’s truer now than ever. Here are four reasons why.

Hedging Volatility

Obviously 2022 has caused investors to endure plenty of gut-wrenching volatility. This is where dividends can help. As you can see in the chart below, since 1990, companies with the financial strength (i.e., quality) to grow their dividends outperformed during volatile markets.

The CBOE Volatility Index (VIX) is often called the investor fear gauge. The VIX is a real-time index representing market expectations for near-term price changes in the S&P 500. It has averaged 25 over the last three years. In months where the VIX increased, dividend growth stocks beat non-dividend payers by an average of 1.06%. They did even better as volatility rose. So, the more uncertainty there is, the more dividend growers outperform:

Inflation Mitigation

In times of higher inflation, investors are left to scramble for income. On average, leading blue chip dividend strategies typically support a healthy yield somewhere between 3.5% to 4.0%. That 3.5% to 4.0% average weighted yield range is what the proprietary CFS Dividend Growth model targets as well.

These same stocks have a track record of outperforming the most when inflation is the highest. Since 1970, when inflation runs hotter than 6.0%, dividend outperformance is at its greatest:

Better Risk-Adjusted Performance

Regardless of the macro environment, dividend growth stocks can provide a cushion against risk. In fact, since 1950, S&P 500 dividend payers have outperformed both the broader market and non-dividend payers with less risk. And since 1973, dividend payers had an average annualized return of 9.2% versus only about 4% for non-dividend payers (see chart below).

Higher risk adjusted returns are the Holy Grail of investing. Investors should always be in pursuit of better risk-adjusted performance – who doesn’t want better performance with less risk?

Financial Strength

Companies that pay dividends are typically associated with strong financial strength, especially firms that grow their dividends over time. They’re committed to returning money to shareholders. Even despite record dividend payouts in 2022, the S&P 500 constituents payout ratio (i.e., the percentage of profits used to cover dividends) is only 39%, which is well below the 52% long-run average. That means there is significant room for more dividend growth, even in these uncertain times.

These four points taken together sum up why we at CFS believe wholeheartedly in the power of dividend investing. It’s why we target high quality, best-of-breed companies with strong cash flows and dividend yields in the weighted average range of 3.5% to 4.0% that consistently grow their dividends by 5% to 10% annually. This growth rate is key because it means they're doubling their dividend payouts every decade.

Time for a Pause, Part Two

Last week we talked about the cratering money supply, decreasing inflation, and the need for the Federal Reserve to pause its rate hikes. Since then, Princeton economics professor and former Vice Chairman of the Fed, Alan Blinder, wrote a Wall Street Journal opinion piece on inflation disappearing before our eyes. His commentary provided more data and support for our belief that the Fed should take a step back from rate hiking and observe the effects of its work.

In the article, Mr. Blinder said:

Examining inflation with a different lens shows how we’re basically at the Fed’s target inflation rate of 2.0%. This is a powerful argument that the Fed's target has been reached. Further confirmation came last week, when inflation dipped again, showing a 6.5% annual increase in prices. The 6.5% rate is down from 7.1% the month prior and is the lowest reading in more than a year.

This may be what breathes life back into the bullish camp. That said, whether the market can make this transition away from the Fed’s aggressive tone and put together a positive inflationary narrative remains to be seen. Thus, the rest of January will be huge for market sentiment as we absorb the inflation data and fourth quarter earnings. We’ll know a lot more about the health of the domestic and global economy in the coming weeks.

We already know inflation peaked back in June (see chart below). We now know consumer inflation also slowed for a sixth straight month in December 2022.

That’s great news, but only part of the story. On Jan. 18, we’ll find out how business inflation is doing when the latest producer price index report is released. That will be telling.

Sadly, the market has been deaf to the empirical evidence about slowing inflation and more swayed by the Fed’s vocal marching orders about future rate hikes. As we know, the growth in the money supply has turned negative for the first time ever. Remember, it’s important to mind the money supply because money supply growth is often one of the most helpful measures of economic activity and an indicator of coming recessions.

Typically, recessions tend to be preceded by slowing rates of money supply growth (like we’re experiencing now). The current drawdown on the M2 money supply reflects the rebalancing of all the stimulus money injected into the system, which was a catalyst for our inflationary problems.

However, money supply growth tends to begin growing again before the onset of a recession. So, hopefully we’ll see the money supply start to grow again. If it does, it will be another data point that perhaps points the market to more bullishness around the midpoint of 2023.

Considering how much money and stimulus was created by both the Fed and Congress, this determined move to reduce M2 money supply at a time when fourth quarter gross domestic product is forecast to grow by 3.8% (see below) and unemployment is at 3.5% is consistent with letting the economy run on its own.

The fact that we had a sixth straight month of lower trend inflation smacks of a compelling debate that perhaps the bears calling for the S&P 500 to dive to 3,000 have it wrong. Is this premature on our part, before the macro picture has begun to completely pivot? Maybe. Time will tell but remember that the equity markets are forward looking.

That said, the sectors jumping the most in 2023 so far are deeply cyclical. As we say, it’s wise to follow the “big money,” and those inflows into cyclical sectors have been stunning. The jumps of 3% to 6% on big volume days in deeply cyclical stocks may be the wake-up call we all need…as long as the Fed doesn’t mess things up (which, unfortunately, will probably happen).

Securities sold through CoreCap Investments, LLC.  Advisory services offered by CoreCap Advisors, LLC.  Cornerstone Financial and CoreCap are separate and unaffiliated entities.

Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Studies. Currencies investing are generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

The S&P 500 Composite Index is an unmanaged index that is considered representative of the overall U.S. stock market. Index performance is not indicative of the past performance of a particular investment. Past performance does not guarantee future results. Individuals cannot invest directly in an index. The return and principal value of stock prices will fluctuate as market conditions change. And shares, when sold, may be worth more or less than their original cost.

 Investing involves risk and you may incur a profit or loss regardless of strategy selected.

There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct.

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