The third-quarter earnings season is getting off to a good start with solid numbers coming from the big money center banks. There is rising optimism that the stock market, and specifically the torch-bearing tech sector, will deliver strong Q3 sales and earnings as capital investment into artificial intelligence (AI) continues to be robust according to Wall Street analysts.
The Atlanta Fed has bumped their growth rate for the third quarter back up to 3.2% from its prior lower revision of 2.5%, implying they see the recent half-point rate cut by the Fed as impactful to corporate earnings. The back half of October is historically bullish because of earnings season. There is over $6 trillion in cash on the sideline and gas prices are under $3.00 per gallon in many parts of the country. It’s a good set up for a higher stock market.
The most recent employment and inflation data for September has set back expectations for further aggressive rate cuts for the balance of 2024. As of Oct. 11, the CME FedWatch Tool is forecasting a 90% probability of a quarter-point rate cut at the Nov. 7 Federal Open Market Committee (FOMC) meeting and an 84% chance of another quarter-point cut at the Dec. 18 meeting, which would have the Fed Funds Rate ending the year at 4.25-4.50%. This glide path to a lower short-term benchmark is absolutely bullish for bonds as well at dividend growth stocks.
There are now many stocks with dividend yields that rival Treasury and investment grade corporate bond yields. The big advantage of dividend income versus corresponding fixed income yields is the tax treatment of income. Fixed income is taxed at ordinary income tax rates per the investor’s tax bracket. The maximum tax rate applied to qualified dividends is 20%. The highest federal tax rate for income is 37%, and then every state has an additional income tax applied.
Translated, a bond paying 4% to a high-income earner nets out 2.52%, whereas a qualified dividend paying 4% pays out a net yield of 3.20%. This is a material spread when one considers the “it’s not what you make, but what you keep” aspect of this proposition, but also the inflation component. At present, annual inflation is running at 2.4%, so earning 4% in the fixed income market and adjusting for inflation is potentially a zero-sum game for the high-income earners.
The main challenge for investors seeking high-dividend yields is that dividend growth hasn’t kept up with the market. Dividend yields from blue-chip U.S. companies have been trending downwards over time, evidenced by the Standard & Poor’s 500 Index dividend yield of approximately 1.78% at the end of 2022, lower yields throughout 2023 and currently only 1.21% for the SPDR S&P 500 Index ETF (SPY).
This is well under the index’s long-run average yield of 2.91%. In fact, dividend yields have remained relatively low (below 3%) since 1992. The slowing of dividend growth over time is one more sign that small dividends remain the new normal. A quick review of the history of the S&P 500 reveals just how abnormal sub-3% annual yields have been since the 1800s. Because of highly proactive monetary policy and the rise of technology stocks, today’s dividend investors have a bigger challenge to find great yields among great stocks. But they are out there, just not in big numbers.
The sharp change in S&P 500 dividend yield traces back to the 1990s. For example, the average dividend yield between 1970 and 1990 was 4.21%, according to NYU Stern’s Aswath Damodoran. It declined to 1.95% between 1991 and 2007. After a brief climb to about 3.15% during the peak of the Great Recession of 2008, the annual S&P 500 dividend yield averaged just 1.98% between 2009 and 2019. From 2020 onward, the dividend yield fell below 2% and has stayed below since then, ranging between 1.24% to 1.78%.
Looking at the market’s 11 sectors, the highest yielding are the Utilities Select Sector SPDR ETF (XLU) paying 2.79% and the Consumer Staples Select Sector SPDR ETF (XLP) paying 2.58%. It seems clear that conventional ETF sector investing isn’t going to satisfy the need for qualified dividend yields. This is where investors will have to exercise some due diligence to find those blue-chip and not-so-blue-chip stocks that pay dividend yields in excess of 4% to stay ahead of long-term inflation and the tax man. It’s the world investors live in, and it is only going to get more difficult.
Here are six examples of blue-chip stocks that fit the profile of paying outsized yields and have bullish chart patterns (up and to the right) that include:
Verizon Communications Inc. (VZ) — 6.30% yield.
AT&T (T) — 5.20% yield.
Dominion Energy Inc. (D) — 4.75% yield.
Kinder Morgan Inc (KMI) — 4.66% yield.
Bristol Meyers Squibb Co. (BMY) — 4.60% yield.
Prudential Financial Inc (PRU) — 4.20% yield.
These are just a handful of stocks where a well-rounded portfolio of dividend stocks can be crafted for the balance of 2024 and 2025 as this new lower rate cycle takes hold. It’s an ideal time to lock and load in qualified dividend yields and look for potential capital appreciation to also reward investor portfolios on a total return basis.
