Stock investors might be interested to know what portion of the U.S. market’s long-term return is attributable to dividends, as opposed to price appreciation. The answer: 50.8%. Since 1871, the S&P 500’s total return has been 8.89% on an annualized basis, versus 4.37% on a price-only basis.
Slightly more than half of stocks’ long-term returns have come from dividends, in other words. Assuming that this proportion will hold in the future, then the stock market’s expected long-term return is now just 3.8% annualized. That’s because the S&P 500’s SPX, +0.49% current dividend yield of 1.9% — half of 3.8%. That’s barely a third of the stock market’s historical total return.
Stock bulls have two major rebuttals to this otherwise sobering forecast, and I want to deal with each:
1. Buybacks make up for a lower dividend yield:
One of the rebuttals focuses on the increasingly large role that share repurchases (buybacks) have played in recent decades. It seems plausible that much of the money that companies would otherwise have spent on dividends is being spent instead on share repurchases. On the theory that those repurchases increase share prices more than they would have otherwise, this would mean that the proportion of stocks’ future total return coming from dividends will be smaller than in past decades.
I’m not so sure about this argument. Since 1982, which is when Congress enacted a new rule that in effect opened the floodgates for buybacks, higher dividend yields have been associated with greater subsequent price appreciation in the S&P 500 — not lesser. This has been the case regardless of whether we focus on price-only returns over the subsequent one-, five-, or 10-year periods.
That’s just the opposite of what we would be seeing if the increased buyback activity were actually leading to higher prices for the market as a whole.
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Though it’s beyond the scope of this column to speculate why buybacks haven’t led to faster price appreciation, I note that one possible reason is that net buybacks have been a lot smaller than gross buybacks. That’s because, even as companies have been repurchasing their shares at a fast clip, they have also been issuing a lot of new shares.
2. Earnings grow faster in a low-yield world:
Another of the rebuttals is that company earnings will grow faster to the extent a company takes the money otherwise paid out in dividends and invests in research and development. This prediction rests on a solid theoretical foundation that traces to economists Merton Miller and Franco Modigliani. According to a theory they developed many decades ago, investors should be indifferent to a firm’s dividend payout ratio, since any amounts that firm chooses not to distribute as dividends will be available for it to invest in future growth. (Miller won the Nobel Prize in economics in 1990; Modigliani in 1985.)
Though I am reluctant to question a theory developed by such eminent economists, I note that it was developed before share repurchases began to play a large role. To the extent that companies are taking the money they would otherwise have spent on dividends and repurchasing stock instead, they are not investing in their future growth. That would lead to no expectation of faster earnings growth rates from lower dividend yields.
Is repurchase activity the beneficiary of lower dividends? To get a general sense, consider firms’ total payout yield — which combines both their dividends and their buybacks. According to Yardeni Research, the S&P 500’s current total payout yield stands at 4.5%. That compares to an average dividend yield of 5.0% for the period between 1871 and 1982, which is when buybacks began to play their bigger role. This back-of-the-envelope comparison suggests that the bulk of the money saved from lower dividends is going into buybacks rather than investments in future growth.
The historical data is consistent with this general skepticism of the bulls’ argument. Since 1982, there has been no detectable relationship between a lower dividend yield and a faster subsequent growth rate in the S&P 500’s earnings per share. This was true over the subsequent one-, five-, and 10-year periods.
Some even argue that higher dividends actually lead to higher earnings growth rates. I don’t need to go that far in order to take issue with the bulls, of course, but you should be aware of the argument. It received prominent mention in a 2003 article in the Financial Analysts Journal by Cliff Asness of AQR Capital Management and Robert Arnott of Research Affiliates, entitled “Surprise! Higher Dividends = Higher Earnings Growth.”
To be sure, their argument is by no means the final world on this subject. Jeremy Siegel, the professor of finance at the Wharton School of the University of Pennsylvania and author of “Stocks for the Long Run,” took grave issue with Asness and Arnott when their article was published. And in a recent email, Siegel told me that he has enjoyed the last laugh: Even though the dividend yield in the early 2000s was quite low, earnings growth since then has been “extraordinary.”
As with any weighty issue in the financial arena, this one won’t be resolved anytime soon. Yet, since we don’t have the luxury of waiting for this debate to be resolved once and for all, we have to decide what to do with our money now.
The question for each of us, therefore, boils down to our confidence that companies are using the money saved from having lower dividends to invest in their future growth. To the extent we believe they are, then today’s low dividend yield won’t be a source of concern. If we don’t have that confidence, however, then the stock market’s future return is likely to be a lot less than its historical average.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com. Create an email alert for Mark Hulbert’s MarketWatch columns here (requires sign-in).
