Stock market returns come from two main sources. The first is capital gains, which is the increase in the price of a stock. This is what most technical analysts and traders focus most on – pure price action on a chart. Dividends are the second source. These are payments made by a company to its shareholders out of its profits. When you own dividend-paying stocks, you receive a share of the company’s profits, usually on a quarterly basis.
Stocks that don’t pay dividends are seen as growth companies exposed to the cyclicality of the market, as they reinvest their profits into business operations. These companies tend to be more volatile as a result. Stocks that pay dividends tend to have less price fluctuations and are more mature.
Growth stocks which are driven by capital appreciation are attractive, while dividend investing is seen as stodgy. However, dividend investing is incredibly important in the long run, accounting for 30%-40% of stock market performance on average.
There are cycles where investors prefer stocks that are more tilted toward capital appreciation, and times where investors prefer stocks that are less volatile and are being driven by dividends. What often triggers this cycle is a turn in interest rates (because of the competition they offer from an income standpoint), as well as moments of fear where investors prefer, for a moment in time, the perceived safety of dividends.
Dividend Stocks Are Starting to Outperform
This is where things get interesting. Dividend stocks have started outperforming.
What happens if the ratio of the SPDR S&P Dividend ETF (NYSEARCA:SDY) continues to run higher relative to the SPDR S&P 500 ETF (NYSEARCA:SPY)? Would that not suggest the pendulum has begun to swing back to the perceived safety of dividend stocks?
There’s more to it than that. It’s also a sector question. Tech stocks do not typically pay high dividends. Utilities, consumer staples, and healthcare stocks do. These are the sectors of the stock market which tend to have less overall volatility and end up being places to “hide” when investors expect an economic slowdown. Could this early relative momentum suggest we are at a cycle turn?
I think it’s possible. Either way, dividend investing makes a ton of sense here in my view, and I think a major change is underway.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
