Dividend Climate Change: What Happens When Interest Rates Rise?

Includes: SPY
by: Richard Bloch

The past few decades have provided excellent opportunities for dividend investors, but that could change. It may not be next week, next month, or even next year, but what happens when interest rates rise?

I was reviewing the research Yale University Professor Robert Shiller has compiled on historical stock market data, specifically how dividend yields compared to interest rates in two time periods. I looked at the 1970s when both short and long-term interest rates soared to levels hard to even envision, and the period from 1985 on.

First, here’s a look at dividend yields and interest rates from 1965 to 1985. I’ve included both the ten-year bond yield, and the rate for six-month CDs.

It would have seemed mighty tempting to ditch stocks for CDs back when you could get double-digit rates for simply putting your money in a bank. But it was a whole different world once the stock market began taking off again in the early 1980s.

Based on Professor Shiller’s dividend data, I created a hypothetical $10,000 portfolio of stocks, assuming reinvesting dividends, from 1985 on and compared it to what you would have earned in 6-month CDs.

With relatively low short-term rates that have tended to fall over the years, stocks were definitely the asset class of choice. And the compounding effect of reinvesting dividends worked out very well for patient investors.

Just to clarify, this is a hypothetical level of performance based on Shiller's averages. High-quality dividend stocks could have performed much better (although some may have not performed as well).

Yet that same approach would have worked out very differently for that $10,000 portfolio starting in 1965 as interest rates rose into the 1970s.

One issue with this analysis is that when you go back almost 50 years, you’re not always comparing apples to oranges. I used nominal data which does not account for inflation and the stock market was very different back then.

For example, today investors have more choices. Fixed-income investors can easily buy CDs and bonds in currencies other than the dollar – and ETFs make it a lot easier for stock investors to buy shares in almost any country with an active stock market.

Another thing that’s also changed is the nature of the S&P 500 companies. US companies do a lot more business outside the U.S. than ever. For example, how many McDonald’s were there overseas 40 years ago? Probably not many.

Payouts declining: A long-term trend?

One comforting aspect of the 1965-1985 chart above is that while the CD portfolio beat the stock portfolio, there were still some very decent gains for stocks. And the high interest rates of the late 1970s sort of cleared the air to allow a multi-year bull market to begin in the early to mid 1980s.

What’s not comforting is what I saw in the payout ratios in Professor Shiller’s data. Here’s a chart showing the ratio of dividends to earnings of the S&P 500. (Note: I had to crop the chart to show the period of the financial crisis because earnings were so dismal, yet many companies managed to maintain their payments)

As the 1960s began, companies seemed to pay 50% of their earnings in dividends, but that’s been declining to the point where we’re lucky if 30% of earnings are distributed. Remember, that’s an average, which could reflect that fewer companies pay dividends at all, but those that do still maintain consistent payouts. Still, it’s an interesting aspect of Professor Shiller’s data.

Many of us have never lived through a time when a competitive mortgage rates could be 1% per month and a car loan might have an APR of 18% or more. It was a great time to be lending out money, but unfortunately that meant stocks had to take a breather.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.