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If You're Annoyed By Bitcoin, You Will Probably Like This

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The invisible currency craze is taking even more attention away from investors’ goals.

This is not an article about Bitcoin, but it is about the misdirection that results when investors lose their poise, start to suffer from FOMO (fear of missing out) and forget what their true investment objectives are.  Investor behavior regarding Bitcoin and the blockchain “revolution” has been called everything from the next internet to “it should be illegal” by Nobel Prize winner Joseph Stiglitz to “crazy” by none other than Vanguard Founder Jack Bogle.

Meanwhile, as discussed extensively in this column during 2017, it’s been a tough year for investors who prioritize generating income from their portfolio, especially if they use high-yield stocks to do so.  And while those high-yield stocks are recently starting to participate more in the continued rally by the S&P 500 and other headline stock indexes, this is a good time to raise the following concern:

Has income investing as a primary objective been forgotten?

With the Nasdaq, FAANG stocks, Bitcoin and the chaotic political scene in D.C. taking all the air out of the room, it seems to me that the simple, boring but beautiful endeavor of buying stocks and earning dividend income from owning a piece of those businesses has taken a back-row seat in an arena as large as the Los Angeles Coliseum.  I don’t think it is the case that investors have outright abandoned dividend income investing.  It’s just that it is hard as an individual investor to avoid getting dragged into discussions and excitement about what is trendy.  This is the case for some investors today and it will always be the case as long as there are humans and the internet.

So here, I am going to slow things down and show you something about today’s market environment that is not sexy or slick, but can potentially make a difference in your wealth and objectives in the years ahead.  You see, we have likely entered a “melt-up” phase of this long bull market.  That means that all the noise you hear about investment approaches that are “hot” but have little or nothing to do with your income objective will only get louder.  The old expression was that you know we are in the melt-up phase when your taxi driver is giving you stock tips.  Substitute Uber or Lyft for taxi and I suspect we are there.

Here are some summary results of a study I did with Becky Gallagher, a research analyst at my firm, as part of an upcoming whitepaper on dividend investing.  This is as big an “a-ha” moment as I have had in the past 10 years, and I am immersed in this stuff.  Here is what we did and what we found:

Using our handy Bloomberg terminal, we studied the entire membership of the S&P 500 Index, as it stood at the start of each calendar year for the past 20 years, back to the start of 1998.  At the start of each year, we divided the S&P 500’s holdings into 4 groups sorted by their dividend yield.  Stats geeks will refer to these as “quartiles.”  Roughly speaking the 125 stocks with the highest dividend yields were in “Group 1,” the next 125 highest yielders were labeled “Group 2,” “Group 3” and “Group 4” were constructed in the same manner.  Note that many “Group 4” stocks don’t pay a dividend at all.

We weighted the stocks in each of the 4 groups by their market capitalization and measured the return of each group for the calendar year.  Then, we reclassified them, “rebalancing” the groups if you will.  For instance, if a stock had a very high yield but then went way up in price that year, it might start the next year in Group 2 or Group 3.  This way, we kept the methodology fresh each year.

I highlighted in yellow the most significant conclusions I took from this table:

Group 1 stocks (the highest quartile of dividend yields in the S&P 500) were the best long-term performer since 1998.  That group performed better than the other 3 groups/quartiles, and better than the S&P 500.  And when you start from the year the dot-com bubble burst (2000), the outperformance is dramatic.  This is so important to recognize because if we are near the top of the equity bull market, those returns since 2000 are, historically speaking, more relevant than those starting in 1998, which included the last major S&P 500 melt-up.  The more you are concerned history will repeat, the more interested you should be in high yield stocks.

  • There have been 3 years among the last 20 in which Group 1 produced what I would consider to be inferior returns versus the S&P 500. I define that as when Group 1’s return was less than ½ that of the S&P 500 in a calendar year in which the S&P 500 rose more than 5%.  That’s why 2005 and 2015 are not highlighted.

    1. The first of those 3 “inferior” years for Group 1 stocks was 1999, when the S&P 500 rose by nearly 20%, mostly on the back of Group 4, the stocks with no or low dividend yield. Group 1 did not even make a profit!
    2. The second year was 2007. Gains were more democratic across Groups 2, 3 and 4, but Group 1 was again in the red.
    3. The third year is this year, 2017. And while Group 1’s return is decidedly positive, it is in a different area code as compared to the other 3 groups.  And from where I sit, market sentiment toward Group 1 stocks and Group 4 stocks is very reminiscent of 1999.
  • Group 1’s long-term returns since 1998 were higher than the S&P 500, and more than double that of the Barclays US Aggregate Bond Index.

And, when you move the start date up to the year 2000, Group 1’s returns are far greater than those of not only the S&P 500 and the bond index, but more than 3 times that of Group 4, the one that is roaring this year based on strong performance of stocks that pay little or no dividend yield.  In fact, only Group 2 keeps pace with Group 1 over this period, which reinforces the idea that stocks with above-average dividend yields are an investment market segment that has been a strong performer in periods that cover both bull and bear markets.

That outperformance by higher-yielding stocks is due in large part to how well Group 1 stocks did when the dot-com bubble burst wide open.  They were up in 2000 and 2001, and performed very well on a relative basis in 2002.  This is something to keep in mind when Bitcoin is grabbing headlines and seemingly “old school” approaches like investing in high yield stocks are written off.

As you probably realize, the first 2 years in which high yield stocks produced inferior returns were, in retrospect, a warning sign to investors.  We will see if 2017 is carrying that same message.  But as I alluded to, I see many similarities to the 1999 environment, though not quite as severe.

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