Get Jim Cramer's picks for 2006. Dividends made a comeback in 2005. And it looks like the trend is here for the long term. After bottoming at 1.12% in March 2000, the yield on the stocks in the Standard & Poor's 500 has climbed to a recent 1.83%. That's still far shy of the historical average yield of 3.92% for the period that began in 1925. But according to recent projections by Boston money manager Eaton Vance ( EV), the trend toward higher dividends will run at least through 2010. The payout ratio -- the percentage of earnings a company pays out in dividends -- will rise during that period to 50% from today's 32%. To put that in context, the dividend payout ratio since 1936 has averaged 54%. This swing of the pendulum from historic lows to something like the long-term average will do more than just put more dollars into the quarterly dividend checks that companies mail out. It will change market volatility, shift the relative desirability of stock sectors and amend the growth rate in the economy as a whole. Let's take a look at the difference this dividend comeback will make over the next five years.
But think how bad the total return on stocks would have been for that period without dividends. The dividend yield for those years, again according to Ibbotson, averaged 3.47%. Take away dividend payments (and the return investors got from reinvesting those dividends), and capital appreciation -- the increase or decrease in the price of stocks -- averaged just 1.42% a year. When stocks pay out 5.37% in dividends, as they did in 1974 after and because of the market plunge that year (large company stocks fell 29.72%, Ibbotson says), some investors will decide to hold on rather than sell. And that dampens the market's fall. This incentive wasn't in view in 2000 when such stocks as Intel ( INTC), Microsoft ( MSFT) and Cisco Systems ( CSCO) paid a grand total of zero, zip, nada in dividends. Capital appreciation was close to the only game in town. When stocks stopped going up, investors didn't see any reason to own them. Certainly, they weren't worth buying for their dividends. In fact, I suspect that the lack of significant dividend yields on the stocks that make up the Nasdaq Composite is one reason it has taken so long to recover the ground it lost in the bursting of the bubble. Paltry dividends kept many value investors from buying these stocks -- and value investors play a critical role in the recovery of any heavily damaged stock price. (The Nasdaq 100 Index, which includes the big-cap Nasdaq stocks, has fared even worse than the Composite index. It lost 83% of its value from its peak in March 2000 to its bottom in October 2002. Today, the index is at about 35% of its 2000 peak. The Composite's value is 44% of its 2000 high.)
But that rule is only true because of the historical dividend yield of 3.92% -- and the way dividend yields rise when stock prices decline. Take away the average dividend, and suddenly, long-term investors in the 15-year periods that began in 1927, 1928, 1929 and 1930 lost money. And the 15-year period that began in 1960 comes close to showing a loss. Looking at 10-year returns, investors don't have to go back to the Great Depression to see that without the historical average dividend yield of 3.92%, it is possible to lose money with a 10-year holding period. It happened in 1965-1974, in 1966-1975 and in 1969-1978. That's not ancient history.
This dividend differential is important. As baby boomers retire, they will be looking for yield and will be more willing to trade higher-but-uncertain capital appreciation for lower-but-more-certain dividend income.
Large institutional investors are starting to wonder if maybe there is a capital-spending problem. Back in September, 50% of global fund managers in a survey told Merrill Lynch that companies aren't investing enough in their own businesses. I can understand why. One effect of the new global markets -- where, overnight, a Chinese or Indian company can build a factory and undercut an established competitor's prices, killing profit margins -- is that investing in production is riskier than ever. (It's also more essential than ever. If a company doesn't invest in constantly reinventing its factories and work force, it becomes increasingly vulnerable to global competition. That, however, is another story.) In the 1990s, too many dollars reinvested by companies led to huge overcapacity and a stock-market crash that decimated major sectors of the technology economy so badly that they're still struggling to recover. In the current decade, too few dollars reinvested by companies could lead to more jobs going to overseas competitors and to lower economic growth in the U.S. somewhere down the road. Somewhere in here there's a balance. Let's hope that the current dividend comeback finds it. And meanwhile, I think investors looking to outperform the market will pay more attention to stocks with decent and growing dividend yields in the years ahead. Get Jim Cramer's picks for 2006.