These are extraordinary times in terms of long-term bond yields. On the one hand, investors are sceptical about stock market returns after a poor showing during the past decade. On the other hand, bond yields are so low that it does not feel right to invest in long-term bonds. Currently, the 10-year bonds yield a measly 2.4% and real yields are below 1%. A ballooning US budget deficit and the threat of inflation keep several investors away from bonds. Some of these investors instead head to the stock market and invest in high dividend stocks. Is this a good strategy? Can high dividend stocks beat 10-year bonds or the stock market?
This is not the first time in history when 10-year bonds yield less than 2.5% and the stock market performed terribly in the previous 10 years. We were in a similar situation right after the great depression. Between May 1938 and October 1950 10-year bond yields were below the 2.5% threshold. We can take a look at the performance of the stocks with the highest dividend yield during this low 10-year interest rate period and have an idea about the future performance of high dividend stocks. Insider Monkey compiled the list of top 20 dividend yielding stocks each year among the largest 200 stocks. The largest stocks are usually more mature companies with stable businesses and sufficient cash flow to support high dividend payments. This way, we exclude distressed companies which happen to have high dividend yields simply because of large declines in their stock prices. Usually dividend yields are correlated within each industry; to provide adequate diversification, we chose to have 20 large cap stocks in our high dividend stock portfolio.
During the 13 years between 1938 and 1950, when 10-year interest rates were below 2.5%, high dividend stocks returned an average of 18.1% (including dividends) whereas value-weighted market returns (including dividends) were only 12.7%. High dividend stocks not only managed to outperform the market by 5.4 percentage points per year, they had higher returns in 11 of the 13 years. The worst annual return of high dividend stocks was -6.7% vs. -11.2% for the market. High dividend stocks provided protection when the market was down. They beat the stock market in all down years. They also beat the stock market every time the stock market increased by more than 20%. If the stocks repeat the same pattern in the following years, investors chasing high dividend large cap companies will manage to beat both the bond and stock markets by a large margin.
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