Dividends Can Help Investors Navigate Volatile Markets Ahead

In light of January’s pullback in U.S. equities, following an uninterrupted nine-month rally, investors are looking to protect their portfolios from a potentially volatile 2010.  With the huge losses of 2008 still fresh in their minds, investors appear skittish about their investments going forward due to uncertainties in the business environment such as the tightening of easy central bank policies, the end of government stimulus, and increased government regulation.  In such a situation, a dividend yield based strategy can improve stability in a portfolio’s returns by smoothing out the influence of risk appetite, while still allowing the investor to chase capital gains.

In its simplest form, a dividend is the distribution of a company’s earnings to its shareholders, usually taking the form of a cash payment.  Although often forgotten or overlooked, the dividend is a key component of a security’s total return and can provide a more accurate picture of a stock’s true value than its market price.  Being a byproduct of fundamental data, the dividend is a true representation of a stock’s underlying strength and helps to filter out speculative interest and “noise” created by investor appetite.  As seen in the tech bubble of the late 1990’s, stock prices can stray far from underlying fundamentals, so using an indicator such as the dividend is key to  revealing a mispriced stock or index.

Since March 2009, stocks have greatly outpaced their underlying fundamentals if priced using the dividend discount model.  Although stocks soared over 50 percent off their March lows, dividends declined during the same period and have showed no momentum in the positive direction going forward.  Investors have recoiled from some of their equity holdings this year, as mixed earnings data and high unemployment have brought into question the economic environment for the near- to medium-term.  If dividends are any indicator, stocks appear primed for a pullback, as long as fundamentals remain weak and the economic environment uncertain.

The S&P 500 Against Its Dividends Paid, 2000-Present

Written by James Russell, CFDTrading Research
Please send any comments about this report to JRussell@fxcm.com