Dividend stocks are a top inflation-fighting investment you want to have in your corner now

Investors are too quick to shun dividend-paying stocks when inflation turns bad. This is because they focus on too short a time horizon. When measured over at least a few years, dividends have historically done an admirable job of keeping up with inflation.

To illustrate how the short term can fail you here, contrast the DJIA to the Dow Jones Industrial Average,
-0.42%
real (inflation-adjusted) yield now with the level it was at in early 2021. At that time, the Dow’s nominal yield was 1.9% relative to the 12-month change in US consumer price inflation (CPI) of 1 .2% — for a real yield of 0.7%. Now, by contrast, with inflation running at an 8.5% annual rate, the Dow is returning 2.1% — implying a real return of minus 6.4%. No wonder short-term investors aren’t impressed with dividend-paying stocks.

But consider what happens when you focus on a 10-year period. The accompanying chart plots the 10-year growth rate of the S&P 500 SPX,
+0.16%
dividends per share (DPS) and CPI. Notice that to an impressive degree over the past century, the two data series have tended to rise and fall together. The correlation coefficient of the two series is a statistically significant 0.61.

This correlation would be even stronger if the last two decades were not included, as DPS growth rates have risen significantly in recent years as inflation has declined. These different trends are most likely the exception that proves the rule, as the difference was likely caused by an increase in share buyback activity among dividend-paying companies. All other things being equal, buybacks cause dividends per share to grow faster than total dividends.

The strong historical correlation means that DPS tend to grow faster when inflation is higher, and vice versa. That’s exactly what you want from an inflation hedge. You just have to be patient.

The era of stagflation

Another example of the inflation-hedging potential of dividend-paying stocks comes from the stagflation era of the 1970s through the early 1980s. This era is often Exhibit A in financial advisors’ case for why you should look elsewhere than dividend-paying stocks to hedge against inflation.

Consider the nine calendar years from the beginning of 1973 to the end of 1981, during which the consumer price index rose at an annual rate of 9.2%. Over that period, the top 30% of stocks with the highest dividend yields produced an annualized return of 9.9%, according to data from Dartmouth College finance professor Ken French — or 0.7 of an annual percentage point better than inflation.

The S&P 500’s dividend-adjusted return, by contrast, was 5.2% annualized over that same nine-year period—equivalent to a real return of minus 4.0% annualized.

The return on this portfolio of high-yield stocks does not include transaction costs, so on a net basis it would be lower. Still, returns probably won’t be much lower because a high-dividend portfolio tends to have low turnover. But it would be impressive if this portfolio even kept up with the market itself, given the stagflation era’s reputation for being terrible for stocks.

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Even if this high-yielding portfolio didn’t beat the market, it’s indicative of how much better it performed than a second portfolio that included 30% of the lowest-yielding stocks. This low-yield portfolio produced a return of 5.0% annualized over the same period. Given that the return on this second portfolio is calculated in the same way as the high dividend one, and given that their turnover rates should be similar, the spread between the two – 4.9 percentage points – should be a fair assessment of the dividend-paying advantage stocks paid over little or no dividend during the stagflation era.

Finding Dividend Winners

If you’re convinced by these historical reflections to consider dividend-paying stocks now, be careful not to overload your portfolio with the highest-yielding stocks. Such stocks tend to be particularly risky because their high yields reflect the market’s perception that their dividends are volatile.

It is far better to choose less risky stocks with strong balance sheets. Consider only companies that have received high quality and safety ratings from independent rating agencies. Choose companies that have a long history of not only paying dividends, but never cutting their dividends. You don’t necessarily have to pick the stocks with the highest current yields, but you’ll find companies whose dividends per share are likely to keep pace with inflation.

Mark Hulbert is a regular contributor to MarketWatch. Its Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected]

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