Special Dividends, the Fiscal Cliff, and the Primacy of Trend

by John Jagerson and Wade Hansen | November 29, 2012 8:14 am

Several firms are announcing special dividends[1] to their shareholders before the end of the year. Many analysts expect tax rates on dividends to increase at the end of the year as part of the so-called fiscal cliff. But this scenario has unfolded before, and traders can learn a lot from what happened in 2010.

Bottom line? It might be tempting to try to take advantage of rising prices before the dividends are paid, or the expected decline after the ex-date, but look carefully before making a decision.

Special and regular dividends have two important dates to watch. First is the ex-date, when the stock starts trading without the dividend. This is the most important date to watch. If you owned the stock the day before the ex-date, you can sell on the ex-date and still be paid the dividend later, on the pay-date — the day the company actually sends the dividend to its shareholders of record.

Las Vegas Sands (NYSE:LVS[2]) announced a special dividend on Tuesday, Nov. 27. The dividend is $2.75, which represents a yield of 6.2% based on the stock’s closing price on Nov. 26. The stock jumped 5% on the announcement as investors rushed into the stock before the ex-date, which has been set for Dec. 6. Similar price jumps can be seen in Movado (NYSE:MOV[3]), Costco (NASDAQ:COST[4]), and Sturm Ruger (NYSE:RGR[5]), among others.

There are two things we can assume about the special dividend process. First, the stocks will likely remain elevated if not continue to rise following the announcement of a special dividend, through the day before the ex-date in December. Second, the stock will likely drop by the amount of the dividend at the open on the ex-date.

Can traders — especially option traders — take advantage of that market movement? Maybe.

Let’s answer the easiest part of that question first: Will a drop in price on the ex-date create losses for call holders or gains for put buyers? No. Everyone already knows that stocks drop by most of the value of the dividend on the ex-date. Theoretically, if everything else were held perfectly constant, we would all expect the stock to drop the entire divided amount. If everyone already knows this, then the put and call options will already be trading based on that information. So holding everything else constant, the calls and puts would remain at the same price (minus a little time value erosion) on the ex-date as compared to the day before.

(Side note: On average stocks only drop about 85% of the dividend amount, but this data point is still widely known and will be priced into the options already.)

Now for the trickier part of this question — what should we expect the stock to do following the ex-date? Will fair-weather shareholders, who were just in it for the dividend, leave the stock and drive its price lower through the month of December? Or is there an argument to be made that a large dividend is a sign of confidence in the company from management that will attract new shareholders and drive the price higher?

The answer depends on the underlying stock. For strong stocks already in an uptrend, like COST, we’d expect newly minted holders to stick around. But in the case of channeling or down rending stocks, like LVS, we’d expect new shareholders to cut and run. Most technicians will rely on the trend — even during an unusual event.

And we have historical precedent to consider. Although they are uncommon, there have been periods with a glut of special dividends, and we can learn a lot from those circumstances. In fact, the same fear of a fiscal cliff lead to a round of special dividends in December 2010.

Brown-Forman (NYSE:BF.B[6]) is paying a special dividend of $4 a share this December. The company also paid a special dividend in 2010 when fears of tax-cut expirations triggered a round of market-wide special dividends. The stock was already in an uptrend in 2010 and the fundamentals looked good. The stock cooled off a bit following the 2010 ex-date but resumed attracting buyers shortly thereafter. By contrast, Interactive Brokers (NASDAQ:IBKR[7]), a firm that was struggling against tighter margins and chart resistance, also announced a special dividend at the end of 2010. IB paid the dividend in December 2010 and hasn’t recovered since.

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The bottom line is that the adjustment in price from the announcement of a special dividend happens suddenly, so unless you are already in the trade there isn’t much of a chance to do anything to profit from that rally. Stocks tend to follow their trend on average leading up to the ex-date, but the moves aren’t likely to be large. The stock will drop on the ex-date, but that move is already priced into the options once the dividend is announced so there is not a lot for traders to do at that point, either. But there may be a trade once the ex-date has passed and volatility has cooled off. We have found a strong bias for stocks to resume their prior trend very quickly following the dividend’s ex-date.

We are watching the current round of special dividends to see whether momentum starts to pick up based on the prior direction. For example, Las Vegas Sands could treat its current price level as resistance and then decline as investors who have been paid the special dividend leave the stock in December. Conversely, Costco could be expected to break resistance and extend its prior trend beyond September’s highs following its ex-date adjustment. The chart below highlights the contrasting trends between the two stocks and how the technicals could wind up picking the direction for each stock — regardless of the dividend itself.

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These special dividends may present opportunities, but they are likely to be after the dividends are done and momentum has resumed. On balance, the special dividends don’t affect the long-term trend of the stock … but they could create ideal entry points once the ex-date has passed.

Whether we prioritize the bullish or bearish opportunities will have a lot to do with the outlook for the fiscal cliff itself — the original reason for the special dividends. If uncertainty is still looming in December, then bearish trades on stocks like LVS will be much more attractive. But if a consensus emerges that preserves most of the tax benefits traders are worried about, then the bullish opportunities would be more attractive.

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