Stocks’ Rise Doesn’t Rely on Dividends

Evidently, dividends are the new stock buybacks. Yep, after years of "stock buybacks are the only thing fueling this bull market," buybacks have slowed, dividends are up, and now those lovely cash payouts are getting the credit for stocks' continued rise. As the narrative goes, ultra-low bond yields drove yield-starved investors to high-dividend stocks, inspiring companies to raise their payouts, driving demand higher, and sending prices and dividends higher in happy lockstep. But, they warn, it may not last: With dividends representing a steadily larger chunk of earnings, and earnings not so hot lately, payouts might not be able to keep rising, and some firms might have to cut. And if that happens, bye-bye rally. Frankly, it is one of the more convoluted hypotheses we have ever heard, and it doesn't hold water. Dividends' and stocks' tandem rise is coincidental, not causal, and this bull market should continue regardless of what companies do with their dividend streams.

Now, we'll grant one thing: Dividends' rise as a percentage of earnings-also known as the dividend payout ratio-is anomalous in recent history. The dividend payout ratio fell during the prior two bull markets (Exhibit 1). Dividends per share were largely flat during the 1990s bull's second half, but rose during the 2002-2007 bull as stock buybacks reduced share count (Exhibit 2).

Exhibit 1: S&P 500 Dividend Payout Ratio

Source: FactSet, as of 8/25/2016. S&P 500 Dividend Payout Ratio (12-month trailing), 1/1/1996 - 8/24/2016.

Exhibit 2: S&P 500 Dividends Per Share

Source: FactSet, as of 8/25/2016. S&P 500 Dividends Per Share (12-month trailing), 1/1/1996 - 8/24/2016.

Right off the bat, this guts the notion that stocks can't rise if dividend payouts don't. They have in the past and probably will again. Of course, bond yields were a lot higher then, exceeding dividend yields. Today, dividend yields swamp bonds, hence the concern. To which we'd say: Where is the evidence dividends are what's pushing up stocks? If they were, high dividend-paying stocks should be outperforming. Now, high-dividend stocks (as represented by the MSCI USA High Dividend Yield Index^[i]) have outperformed cumulatively during this bull market. But theirs was not an uninterrupted run (Exhibit 3). They trailed for long stretches during this cycle, even while-wait for it-dividend yields far exceeded bond yields.

Exhibit 3: US High Dividend Stocks' Relative Returns

Source: FactSet, as of 8/26/2016. MSCI USA High Dividend Yield Index and MSCI USA Index total returns, 3/9/2009 - 8/25/2016.

What's more, if dividends were driving stocks due to low bond yields, that should probably hold true globally, considering yields are extremely low across much of the developed world-in some cases, lower than the US and even negative. Yet globally, too, high-dividend stocks' outperformance isn't at all consistent. (Exhibit 4) They trailed throughout most of 2014 and 2015, despite yields falling across most of the developed world during that span.

Exhibit 4: Global High Dividend Stocks' Relative Returns

Source: FactSet, as of 8/26/2016. MSCI World High Dividend Yield Index and MSCI World Index returns with net dividends, 3/9/2009 - 8/25/2016.

More recently, as stocks fell sharply from the start of the year through February 11, defensive sectors-which tend to have high dividend yields-outperformed by a lot, as investors sought shelter there. But as the chart shows, this was a blip. Assuming a short period of outsized returns means dividends are the main fuel behind stocks' rally is myopic. Relative returns-of any category-often fluctuate quite a bit. Sure enough, that trend fizzled out fairly quickly when the correction ended. Since 2/11, defensive sectors have lagged, and high dividend stocks have performed more or less in line with the broad market. Investors weren't chasing yield earlier this year, they were fearful-seeking safety.

Whether or not companies raise, hold or cut dividend payments from here should have minimal influence over stock prices. That said, earnings weakness and its potential impact on dividends seems vastly overstated. Recent weakness is concentrated in the struggling Energy sector. Plunging oil prices, the result of a global oversupply, is to blame for this, not a weak economy. With Energy earnings having already cratered, and oil prices having largely stabilized, Energy profits may soon cease being a drag on overall earnings growth. Consensus S&P 500 earnings expectations currently reflect this. As of 8/19, 2017 earnings are expected to grow 13.3% y/y.

With net income rising, companies will have plenty of bandwidth to deploy more and more cash as they see fit. Even if they don't raise dividends, they can alternatively use their profits to buy back shares-which increases earnings per share, acquire competitors and/or invest to support future growth, including new equipment and R&D.

Which is really the point. We're in a bull market because corporate America is growing and thriving, fueled by economic growth that's better than most appreciate. Stocks move not on reality, but the gap between expectations and actual results. Earlier this year, many believed the world was heading into recession, and stock prices reflected that gloomy sentiment. Now that the global economy appears to be in much better shape than many thought, stocks have risen to new highs.