Playing It Safe
If you plan on investing over the long term, there will be times when it’s hard to get excited about the market outlook. That might be because you expect the economy to weaken, but it can even happen when your overall vibe is just “meh”. In those situations, it’s sometimes best to take a step back and become more defensive. And if market stress does materialize, being defensive before the stress hits could… pay dividends. Forgive the pun, but it wouldn’t be a proper column if we didn’t start with one, even in Liz's absence. As Liz covered last week, defensive investments generally offer some combination of yield and protection for times of stress. Dividend aristocrats – S&P 500 stocks that have a long history of paying consistently increasing dividends – are an interesting way to keep those elements in mind and play it safe while maintaining some upside potential. This group of stocks also has a higher dividend yield than the broader S&P 500 (see chart below), which enables investors to squeeze out a bit of extra income without having to take on more risk, as would usually be the case in the bond market.
The spread between the dividend yields of the overall index and the dividend aristocrats has widened over the last decade, owing in large part to the increasing importance of mega-cap tech companies in the S&P 500 that don’t pay any dividends at all.
All else equal, higher dividend yields indicate that more of an investment’s value will be realized in the short-term, as opposed to investments that focus more on future growth. Remember: The further into the future you look, the less visibility and more uncertainty there will be.
More Boring or Less Exciting?
For the most part, you know what you’re getting with dividend aristocrats, and there’s value in that… get it? That they’re able to consistently provide dividends is reflective of the maturity of their business models and sectors. Compared to the rest of the S&P 500, the differences jump out at you.
Dividend aristocrats are disproportionately found in Consumer Staples, Materials, and Industrials, which account for nearly 60% of the group but only about 17% of the overall index. Conversely, Information Technology, Consumer Discretionary, and Communication Services account for over 48% of the S&P 500, yet less than 8% of the dividend aristocrats. Moreover, while they’re not specifically segmented out in the chart, none of the “Magnificent Seven” (Microsoft, Apple, Amazon, Alphabet, Meta, Nvidia, and Tesla) are part of the dividend aristocrats despite being over 28% of the S&P 500.
Mature companies, ones that some would say are boring or not exciting, are overrepresented in the dividend aristocrats. They play a vital role in the American economy that gives their businesses relative stability compared to some more exciting options. That level of stability can help provide a defensive ballast to portfolios.
Show Me the Money
Given what we know about dividend aristocrats, the fact that they’re a lower risk way of investing in stocks seems pretty obvious. The theory is all well and good, but in investing it’s equally important to talk about what actually happens. Do they perform better during times of stress? Of course, the disclaimer “past performance is no guarantee of future results” is used for good reason and applies here as well. But, we can also learn from the saying “history doesn’t repeat itself, but it often rhymes”.
Dividend aristocrats have historically outperformed the S&P 500 most during periods of bull steepening, which are periods where Treasury yields fall, with shorter maturities falling more than longer-term ones. This scenario usually happens when the Federal Reserve cuts rates due to economic weakness or recession. A look at history would seem to support what our reasoning told us: Given their defensive characteristics and greater emphasis on income over growth, dividend aristocrats tend to outperform during tough economic conditions and stress.
So where does that leave us today? Market consensus is for the Fed to cut rates five or six times in 2024, and for the economy to decelerate to a period of below-trend growth. That sort of environment would be consistent with bull steepening, which has historically been kinder to dividend aristocrats than the broader index. However, as the last few years have shown us: This is a cycle for the ages and anything can happen.
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