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The Dividend Downtrend

With payouts dwindling as a factor in stock prices, worries rise.

By Richard B. Anderson

Los Angeles Times, Business Section, October 21, 1997

As most of us are aware, the stock market has historically been the most lucrative of all investment alternatives over the long term. Through crashes, wars, depressions and booms, money invested in the market has returned more than 10% annually, compounded, since the year 1925.

But while it's often assumed that the gains in market investments are entirely due to increases in stock prices, but the numbers say that can't be the case.

The Dow Jones Industrial Average stood at 157 in 1925. If prices as indicated by the Dow itself had grown at 10% per year for the intervening 72 years, as market commentators often claim, the index would currently be at more than 150,000.

Its current level of around 7,900 represents an annual gain of a little less than 5.6% per year.

What accounts for the difference? The answer is dividends. The 10% figure assumes all dividends paid over the years were reinvested (and, by the way, that no taxes were ever paid on them).

The dividend yield on the Standard & Poor’s 500 index—in other words, the sum of dividends paid, as a percentage of the index value—has averaged 4.5% per year since 1925. That may not appear to be a princely return, but note that it made up nearly half of that historical 10% annualized total return figure on blue-chip stocks.

What that historical dividend yield means is that a stock investment, throughout virtually all of the modern era, has been like a savings account that pays a respectable rate of “interest” (in the form of dividends), and that also possesses one truly magical extra feature: While the investment is compounding at a steady rate, year after year, every so often there is a bull market and a lot more money goes into the account (in the form of increased share values).

Then that money starts to compound, as well.

The role of dividend income is essential to understanding today's market because over the last four years a fundamental change has occurred--dividends have practically vanished.

The annualized Standard & Poor's 500 dividend yield currently is just 1.6%, near a record low. Which means that even as corporate profits have soared in recent years, stockholder dividend payments made from those profits have not.

In fact, dividends on the S&P 500 have risen 27.2% overall so far this decade, far below the pace of the 1970s and 1980s. Andas stock prices have surged, the slow growth of dividends has made the dividend yield shrink even faster than it otherwise would have. Indeed, this low level is unprecedented; yields have only rarely been lower than 3% since 1926, and never below 2% before the beginning of 1997.

Naturally, when the market is up more than 20% for the year, as it is today, nobody thinks about dividends very much. Those little single digit increases just don't seem very important. Yet the relative shrinkage of dividend returns is an important change, because dividend income has in the long run been a moderating factor, a form of insurance, and a damper on swings in the market.

Dividends serve as a reality check for companies and management, a form of negative feedback that helps to check speculation. As Norman Fosback remarked in Stock Market Logic (1995), "managing earnings is easy--any good accountant can do it. But distributing cold cash to shareholders requires a hard economic decision--once paid out it is irretrievable."

Of course, many companies say they eschew raising dividends today in favor of using excess cash to buy back stock, which, it is hoped, will have the effect of raising their share price in the market. In theory, that’s a way to better reward shareholders because long-term share price gains are taxed at a lower rate than dividends, which are taxed the same as wages.

Yet dividend payments, once set, tend to stay set or rise over time, forcing a certain fiscal discipline on a company. Share-buyback plans, by contrast, may be ephemeral.

More important from shareholders’ point of view, dividend yields have been essential to total investment performance during extended periods of sluggish growth in stock prices or outright market declines.

The Dow Jones Industrial Average closed in 1981 at 875, up only 144 points from its value twenty years earlier and down 15 points from its close in 1971.

In the twenty years before 1981, by contrast, investors could have earned average annual yields of between 2.6% and 5.7% on bonds, depending on the term.

Yet holders of stock did better compared with owners of bonds than the numbers might indicate. Dividend income on the Dow—if reinvested—kept the total investment value of stock rising, so that when share prices began to surge again in 1982, the total investment base of appreciation was that much larger.

What happens now that dividend income has, for practical purposes, disappeared as a factor in returns? Nobody knows.

But it’s safe to assume that a leveling off of stock prices would have a dramatic psychological effect. Suddenly enormous pools of capital would suddenly be earning negligible returns. And because the lack of price appreciation wouldn’t be buffered as much by dividend income as in the past, the effects of any market downturn would probably be much more marked.

True, dividend yields would automatically rise if share prices fell. But just to return to a 3% dividend yield, the value of the S&P 500 would have to fall by nearly 50%, assuming no increase in dividends. Not a happy thought.

Millions of Americans are venturing into the stock market, lured that oft-quoted performance figure of 10%-plus annual returns over the long run. Yet the two components of that performance have been price appreciation and dividend income—and now one of those has become insubstantial.

For all of the discussion lately about the “new economy,” we need to be aware that there is a new stock market as well—and the risks inherent in this new market may not be well understood by most investors.

© Richard B. Anderson, 2004

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