What are the implications of this thesis? If the current 1.7% S&P yield hardly provides a springboard to a new bull market, the new tax equilibrium between dividends and capital gains raises the risk premium for equities, as TIAA-CREF's research director Martin Leibowitz has described in an article in last September's Financial Analysts Journal. Leibowitz also noted that since taxes on interest income remain at old levels, it gives equities yet another advantage.
Ever since the bubble burst in March 2000, many financial commentators have engaged in a great deal of hand-wringing about how the equity investing culture engendered over the last two decades has pushed price/earnings multiples up and simultaneously pushed the equity risk premium down. As Bernstein explained in the May 15 edition of his newsletter, the new tax rate on dividends causes the tradeoff between stocks and bonds to tilt even further in equities' favor. If interest rates rise, as is universally anticipated, the equity risk premium should climb concomitantly since it is one component of the risk premium. "Changes this radical should ignite a big shift in investor preferences," Bernstein wrote to subscribers.
All these cross currents can challenge even the best investment minds. Equities remain richly valued even after spending the last four years going sideways at best. Yet bonds, in the words of Morgan Stanley strategist Byron Wien, resemble the Nasdaq at 5,000. Bernstein acknowledged what many other savants have predicted; that it's quite likely we're in for a period of lower returns from financial assets.
J. Michael Martin, principal of Financial Advantage in Columbia, Md., and a former contributor to Financial Advisor (before he was overwhelmed by the growth of his practice), believes it's a time for advisors to try hard not to lose clients' money. Some of his clients are starting to complain about $150,000 cash balances in their accounts, a trend that partially validates the strategy for him. Bernstein himself remarked that cash, like dividends, gets less respect than it may deserve.
A former director of equity research at T. Rowe Price & Associates, Martin suspects that nominal ten-year returns for equities probably are about 7%, and near 6% for corporate bonds, with inflation at 3.0% or 3.5%. "But you'll probably have to put up with some minus-20% years with stocks," he says. "If the yields on corporate bonds were 6% and the yields on stocks were at 4%, I'd take stocks because they can grow the dividends."
How much companies will raise dividends remains the big wild card. Brian McMahon, president and chief investment officer of Thornburg Investment Management in Santa Fe, N.M., believes there is a lot of room on the upside.
It's a sign of the times that McMahon, who spent most of his career managing and supervising fixed-income portfolios, now is looking for dividend-paying stocks for the company's Income Builder fund. To paraphrase Willie Sutton, if someone is seeking income today, they have to go where the income is. And where it has room to grow.
The sector that McMahon has weighted most heavily is energy. He believes the world's two largest energy companies, ExxonMobil and British Petroleum, which currently yield 2.5% and 3.1%, respectively, have the ability to increase their dividends by 50% as long as the price of oil stays above $30 a barrel.
Additionally, he thinks that companies like ExxonMobil, which has directed free cash flow into share repurchases in recent years, are reconsidering channeling the funds into higher dividends. To some extent, that is already happening. As Bernstein noted at the JP Morgan Fleming meeting, dividends in 2004 are up 8%, compared with an average of 4% annually between 1990 and 1999.
Evidence produced by McMahon reveals that not only are dividend payout ratios relatively low by historical standards but so is the percentage of companies paying dividends. The payout ratio of companies in the S&P 500 remains near a 60-year low, at below 40%, while only 60% of the companies in the Russell 1000 paid any dividend at the end of 2002.