- They are superb long-term investments.
- The reason they have underperformed since March 2020.
- A look at the risks, opportunities, and alternatives.
The above table published quarterly by S&P Dow Jones Indices makes the point quite clearly. It shows an investment strategy based on dividend-paying stocks not only has had superior returns but these returns have been achieved with exceptionally low volatility when compared to other strategies.
But the performance could be improved if investors considered the impact the business cycle has on a portfolio of dividend-paying stocks as represented, for instance, by the two ETFs NOBL or DRGO.
Phase 1 and Phase 2 of the business cycle are characterized by the business decision to replenish inventories following the cuts they had to make in Phase 3 and Phase 4. To replenish inventories, business must buy raw materials, hire more workers, and borrow money to finance the operation, improve and expand capacity.
The virtuous cycle (positive feedback) of hiring, producing, and borrowing strengthens the economy. In phase 2 business activity is strong with the economy growing at an above average pace. This is the time when commodities rise rapidly, accompanied by rising wages and interest rates. In other words, inflation is now becoming an issue.
As business fills up capacity, productivity declines, placing upward pressure on labor costs and hindering profitability.
When consumers’ demand wanes due to the decline in purchasing power, business is forced to cut inventories to match slower sales and to protect profitability. Raw material purchases are reduced, workers are laid off, and borrowing is cut. These decisions bring detrimental results (negative feedback) throughout Phase 3 and Phase 4.
At the end of Phase 4, because of the reductions implemented by business, commodities, inflation, and interest rates are declining. Productivity improves because of lower capacity utilization and profitability hedges higher.
The improvement in purchasing power due to the decline in inflation begins to stimulate demand. Business realizes it must replenish inventories and Phase 1 starts all over again.
Investors can benefit as the business cycle moves through its phases. Phase 1 and Phase 2 are characterized by increases in the price of most assets: energy, metals, most commodities. Rising interest rates are also a feature of this period. Investment in cyclical stocks, as discussed in details in my article An Indicator That Assesses Which S&P 500 Sectors Are Likely To Outperform is particularly attractive in these phases. During Phase 3 and Phase 4, on the other hand, defensive sectors such as staples, REITs, healthcare, utilities, and bonds tend to outperform the market.
The iShares Core Dividend Growth ETF (DGRO) seeks to track the investment results of an index composed of U.S. equities with a history of consistently growing dividends. The performance of this ETF confirms the results shown in the first chart by S&P 500 Dow Jones Indices. It is interesting to note, however, this ETF is particularly sensitive to the trends of the business cycle.
BUSINESS CYCLE INDICATOR
To recognize its sensitivity to the business cycle we have prepared the above chart. The chart shows three panels. The upper panel shows the price of DGRO. The middle panel shows the relative performance of DGRO compared to metals and mining stocks (XME). This is done by computing the ratio DGRO divided by SPY.
The ratio rises when DGRO outperforms XME. DGRO underperforms XME when the ratio declines.
The lower panel shows the business cycle indicator, updated in each issue of The Peter Dag Portfolio Strategy and Management. An exclusive complimentary issue is available to the readers of this article on www.peterdag.com.
Although DGRO has a solid long-term performance, the ETF is particularly attractive when the business cycle declines, reflecting a weakening economy.
The above chart shows how the same relationship discussed for DGRO applied to the ETF NOBL – an ETF focusing on companies within the S&P 500 that have raised their dividends for at least 25 consecutive years.
The chart shows three panels. The upper panel shows the price of NOBL. The middle panel shows the relative performance of NOBL compared to metals and mining stocks (XME). This is done by computing the ratio NOBL divided by SPY.
NOBL outperforms XME when the business declines, reflecting a weakening economy. On the other hand, XME outperforms NOBL when the economy strengthens, and the business cycle rises.
DGRO and NOBL are superb long-term investments as suggested by the data supplied by S&P Dow Jones Indices, showing a strategy based on an investment in dividend aristocrats produces above average returns with low volatility.
The investment results could be further enhanced by investing in DGRO or NOBL when the business cycle declines and investing in XME when the business cycle rises, reflecting a strengthening economy.