I was looking at a long term chart of the Dow Jones Industrial Average, and something struck me as really weird.
The economy & the stock market move in the same direction in the long term. If this is the case, then why did the Dow go nowhere from 1900 to 1924?
There’s not a lot of economic data from that period, but most accounts demonstrate that the economy was growing during most of that period (minus a few recessions). America at the start of the 20th century was a BOOMING nation (crazy population growth, which is good for business).
Recently I read something about Australia’s stock market (I live in Australia). On the surface, it seems as if Australia’s stock market has a lower average annual return vs. the U.S. stock market. But that’s because Australian stocks pay higher dividends than U.S. stocks (that’s the culture here anyways).
And then it hit me.
The S&P 500 EXCLUDES DIVIDENDS. It does not include dividends. Hence, the S&P 500 IS NOT an accurate representation of the “U.S. stock market”. An accurate representation of “the U.S. stock market” would include dividends into the index. That’s what the S&P 500 Total Return Index does. It includes dividends.
*The official S&P 500 Total Return Index only goes back to 1988. But I’ve managed to calculate it back to 1927
Here’s how dividends work. Imagine Company XYZ’s stock price is $100. It issues a $1 dividend. The stock price tomorrow will fall to $99.
The S&P 500 does not take into account this $1 dividend. E.g. If company XYZ issues a $1 dividend, the S&P 500 will fall by $1. On the surface, it looks like investors who owned the S&P 500 (e.g. through $SPY) lost money ($1). But that’s not the reality! Investors now have $99 worth of the S&P 500 and $1 in cash. They can use that $1 and reinvest it back in to the S&P 500!
So straight away, you can see that if the S&P 500 is flat but the S&P 500 companies are issuing dividends, investors are actually making money.
That is why the stock market was flat for practically the first 25 years of the 20th century. Back then, corporate culture favored issuing dividends. Dividend yields on the average stock were much higher than they are today.
*Why don’t you notice the post-dividend downwards adjustment in the S&P 500? Because there are 500 stocks in the S&P 500, and companies don’t issue all of their divdends on the same calendar day. Hence, all the adjustments are spread out over the 252 calendar days. If all the companies hypothetically decided to issue dividends on the exact same day, the S&P would tumble significantly on that 1 day merely due to the ex-dividend adjustment.
How dividend yields have changed over time
Here’s a chart of the S&P 500’s dividend yield over time
Click here to download the data in Excel
As you can see, the stock market’s dividend yield has gone down over time, especially after the mid-1980s.
That’s why to calculate the stock market’s TRUE RETURNS, you need to include the dividend yield back into the S&P 500 Index.
The S&P 500 Total Return Index exists to 1988. I have used monthly data to create a S&P 500 Total Return Index all the way to 1927
Click here to download the data in Excel
Immediately the picture becomes much clearer.
- From 1927 – present, the S&P 500’s average annual return is 5.7%. The average annual return from 1950 – present is 7.6%. (1927 -1950 was a bad time for the stock market)
- From 1927 – present, the S&P 500 Total Return Indices’ average annual return was 9.8%. That’s 4% higher!
- It’s also worth noting that when including dividends, the S&P 500 recovered much faster from the 1929 crash than most people believe. By 1937 the S&P Total Return Index was almost where it was in 1929, but the S&P 500 index (excluding dividends) was still far below its 1929 peak.
The Total Return advantage exists in every single decade, because S&P 500 companies always pay a dividend that >0% (it’s impossible to issue a negative dividend).
From 1988 – present, the S&P 500 yielded an average annual return of 7.99%. The S&P 500’s Total Return Index has yielded an average annual return of 10.4%. This is 2.4% higher
*It’s surprising how 95% of professional investors, traders, and finance professionals think that “dumb” buy and hold yields 7-8% a year. It doesn’t. It’s higher.
So what does Warren Buffett mean when he says “the S&P 500 yields an average of 6-7% a year”?
He’s referring to the fact that the REAL RETURN (inflation-adjusted) of the S&P is 6-7% a year. That is true. Inflation has averaged 3-4% over the past 100 years.
No other asset class comes even close over the past 100 years.
What this means for investors and traders
For starters, this means that the returns in all of our long-only trading models have been underestimated by the dividend yield. Our returns are based on the S&P 500, excluding dividends. Including dividends, returns would be higher.
*Anyone who owns $SPY, $SSO, or $UPRO would earn dividends
Moreover, this explains why it’s better to focus on medium term and long term investing.
All these short term traders are glued to their screens each day, and on a 30 year period they can barely beat buy and hold (7.6% a year) for the S&P 500. When you factor in the dividend yield, these traders are lagging buy and hold significantly. (i.e. if you can’t even beat 7.6% a year, there’s no way you can beat 10% a year)
You need to be more careful with turning bearish than with turning bullish
This is the problem with traders. They are bearish 50% of the time and they are bullish 50% of the time. (Because for a trader, the best thing is if the market goes nowhere and just fluctuates in a small range every year).
This is inherently illogical, because the stock market has a higher % probability of going up vs. down.
The above chart looks at the S&P 500 itself. It doesn’t factor in dividends.
Here’s the same statistic, using my new S&P 500 Total Returns Index from 1927 – 2018
Here’s the same statistic, using my new S&P 500 Total Returns Index from 1950 – 2018
It’s easy to see how bears have a massive disadvantage.
On a side note
And here’s the important point: S&P 500 companies have been decreasing their dividend yields over time.
So while all the permabears complain “this bull market is crazy, the S&P 500 is rallying too fast”, realize that this is partially because dividend yields have gone down. If you have a same total return yield and the dividend yield goes down, that means the capital gains yield goes up (which is what people are normalling refering to when they talk about the S&P 500).
Here’s an example.
- Total return yield is 10%. If in the past, the dividend yield was 4%, that means the capital gains yield (change in S&P 500, ex-dividends) was 6%.
- Total return yield is still 10%. But now, the dividend yield is 2%, which means that the capital gains yield becomes 8%
On the issue of dividend investing
I never understood the purpose behind dividend investing. People love it because “it generates income”. That doesn’t make sense to me.
*Please comment below in the comments section if I got this wrong. I don’t do dividend investing.
When a company issues a dividend, its stock price is automatically adjusted by the size of the dividend.
E.g. if XYZ company’s stock price was $100 pre-dividend, and then it issues a $1 dividend, its stock price will go down by approximately -$1 on tomorrow’s OPEN. Hence, an investor who used to own a $100 stock now has $99 in stock and $1 in cash. It’s the same thing.
So by buying dividend stocks, these investors aren’t earning an “income” for themselves at all. They could just as easily do the same thing by:
- Buying a stock that pays $0 in dividends, and….
- Sell e.g. 3% of the stock every single year, thereby fooling themselves into thinking that they earned a 3% “income” on their shares.
Am I understanding this correctly? Comment below!