Today’s guest post is by a fellow blogger friend of mine, Troy @ MarketHistory.org. Troy’s blog discusses his thoughts on investing, the stock market, and controversial personal finance issues. He runs a privately held investment firm, so he’s got some great insight!
It is true that dividend investing beats index investing (i.e. tying yourself to a benchmark like the S&P 500) in the long term. From 1927 to the present, dividend stocks in the S&P 500 outperformed non-dividend paying stocks by more than 3x (equivalent to a 1.4% difference on average each year)! Clearly the argument should be settled right? All long term investors should just buy dividend stocks and plow their dividends like clockwork back into the market.
But not so fast. For starters, dividends are taxed at the income tax rate in most countries while capital gains are taxed at a much lower rate (e.g. Canada, the U.S., Australia).
Non-dividend or low-dividend stocks tend to outperform dividend stocks when the economy is growing robustly. For example, non-dividend stocks significantly outperformed during the ENTIRE 1990s and 1940s, 2 decades that saw strong U.S. economic growth when adjusted for inflation.
In all honesty, nobody has 30 years to waste. Life is short, which is why I define the “long term” as 5-10 years. This means that in the 1990s I would have prefered non-dividend stocks over dividend stocks by a wide margin.
The key here is to remember that dividend stocks are not the Holy Grail! There’s a timing component to it. You have to know whether the U.S. economy is experiencing robust growth or whether growth is sluggish/deteriorating.
- When economic growth is strong, non-dividend stocks outperform dividend stocks by a big margin.
- When growth is weak or the economy is shrinking, dividend stocks significantly outperform.
This means that if you truly want to outperform the broad stock market, you need to make predictions. You have to “time” the market. Here are 2 ways you can beat passive dividend investors:
1) When to buy dividend stocks and when to buy non-dividend stocks
As I mentioned above, you should buy non-dividend stocks when the economy is growing robustly. Conversely, you should change your portfolio into dividend stocks when growth is sluggish.
How can you tell if growth is sluggish? Simple! Just look at the data, which isn’t hard to understand.
Every country publishes a series of monthly and quarterly economic data. This data covers multiple areas of the economy, ranging from manufacturing to housing to employment to inflation etc.
Let’s look at the U.S. as an example. To understand the state of the U.S. economy, you just need to look at New Home Sales, the Employment Report and Retail Sales. My favorite economist is the famed Bill McBride who publishes these data charts on his blog.
All you need to do is look at the chart. Have the data series being going up (improving) over the past few months? As long as the economy is improving, then it’s probably a better idea to buy non-dividend stocks. But once the data on the chart starts to flatten out or decline, it’s a good idea to switch to dividend stocks.
The U.S. economy is growing nicely right now as you can see in the New Home Sales chart below. Thus, non-dividend stocks (e.g. tech) have outperformed dividend stocks in 2016 and year-to-date 2017.
2) Buy leveraged index ETFs
This is what I do. Leveraged index ETFs track stock indexes such as the S&P 500 or Dow Jones Industrial Average, but they amplify all the price movements. For example, a 2x ETF will turn a 1% daily gain/loss into a 2% daily gain/loss. Using the stock market’s history, I have developed models to predict bear markets and big corrections. Thus I buy leveraged ETFs when it’s a bull market and shift into cash when I think a bear market is imminent.
Since you have to “time” the market ANYWAYS if you want to beat dividend investors, buying leveraged ETFs is better than switching between dividend stocks and non-dividend stocks. I typically buy 3x ETF’s, so a 10% gain in the S&P 500 translates to a 30% profit.
As I’ve explained above, predicting bear markets is not extremely difficult contrary to what most people think. As you can see in the New Home Sales chart above, New Home Sales is either always falling or flat for a long time before a bear market in stocks begins. So all you need to do is buy a leveraged ETF and hold it until either the economy (New Home Sales) deteriorates significantly or flattens out for a few years.