Is it time to play defense? Economists have a fairly simple story to tell about the 2023 economy: things are weird. Inflation raged out of control in 2022, but has been falling in 2023. A volatile stock market remains below its 2021 highs, but still trended positive since the start of the year and may have entered a new bull market. Mortgage rates have tripled, but try telling that to the housing market. Economists and investors alike have issued steady warnings about a coming recession, but it feels like each month’s labor statistics beat the last.
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In other words, nobody really has a handle on what’s happening out there. That said, there are some potentially troubling signs ahead, especially for the third quarter of 2023. Several long-term factors may come to a head in late summer, ranging from top-level issues such as banking instability and delayed-impact Federal Reserve rate hikes to bottom-up issues such as resumed student loan payments. Together, it might all be enough to finally tip the economy into a long-awaited recession.
The right approach to this, as Morgan Stanley argued in a recent brief, might be to start thinking defensively.
“The stock market has managed to stay positive for much of this year. However with interest rates at their highest level in more than a decade and economic growth slowing, not to mention recent turmoil in the banking sector, uncertainty looms large,” writes Daniel Skelly, managing director and head of Morgan Stanley’s wealth management market research and strategy team.
“Additionally, equity valuations are already high relative to earnings – and current earnings estimates may be inflated. As a result, investors may see another drop in the stock market before they can truly declare the bear market over,” Skelly also writes.
In the face of this uncertainty, Skelly says investors may want to consider playing defense in the back half of 2023. In particular, he recommends seeking out dividend stocks. The reason is volatility, as dividend stocks tend to be an excellent buffer against unpredictable markets for four key reasons.
Dividend stocks tend to have built-in support against price volatility. In the short term, when companies issue a dividend to their shareholders, the price of a stock tends to drop. This has to do with a number of factors, most often the fact that new investors don’t want to invest if they’re being left out of the upcoming payments.
That’s not a bad thing, though, because when the share price drops for a dividend-paying stock the asset’s overall yield rises. For example, say you pay $10 per share for a stock that pays $1 in dividends. That’s a 10% yield on your investment ($1 dividend payment / the $10 you paid to receive it). If the share price drops to $8, but the company maintains its $1 per share dividend, that yield floats up to 12.5%.
That builds in a counter-cyclical pressure on the stock. As the share price falls, the yield increases. As the yield increases, more investors will get interested in the stock. That new interest will presumably drive new investment, boosting the share price back up. It’s not a guaranteed cycle, there’s much more going on here, but it can help smooth out volatility relative to stocks that generate their value entirely based on returns.
Historically, dividends have played a much larger role in market returns than many investors realize. As Morgan Stanley notes, in recent years dividend payments have lost ground compared to capital gains. From 2013 to 2022, only about 17% of the stock market’s overall returns came in the form of dividend payments. However, this has less to do with reduced payments and more to do with the explosive gains in stock value over that decade.
Historically, though, dividend payments have accounted for anywhere between 37% and 40% of the market’s overall returns.
Morgan Stanley expects a reversion to norms. “The next several years are likely to be marked by lower equity returns and higher volatility,” Skelly writes, “which could lead dividends to account for a greater portion of total stock market return.”
If the economy does slip into a recession, or even if the stock market simply enters longer-term bear territory, then capital gains-based returns will suffer. Long-term investors who can afford to wait out a downturn will probably be fine, but anyone who is looking to generate returns in the next year or two will probably face much less reliable, often less profitable, share prices. Dividend stocks can help offset that risk.
Signals for Good Fundamentals
Long-term investors should take note too, though.
As Morgan Stanley writes, dividends are a very strong bellwether for the underlying strength of a company. “When a company can reliably pay dividends or even increase them, it likely has a certain level of financial strength and discipline. For investors, this regular income stream can offer some hedge in what continues to be an uncertain stock market. In fact, in 2022, the S&P 500 overall lost about 18%, but the S&P 500 Value Index (which is often used as a proxy for dividend stocks) kept its losses to about 5%, and the S&P 500 High Dividend Index lost about 1%.”
In essence, when a company can afford to pay or maintain dividend payments, it’s signaling that it has significant cash on hand above and beyond its business needs. Now, to be sure, this is not always the case. It is not unheard of for corporate leadership to recklessly reward themselves and other investors at the expense of long-term business interests. So make sure you evaluate a company’s whole picture. If dividend payments take place in the context of weak leadership or an atmosphere of poor judgment, pay attention.
Otherwise, dividends can show that the company has strong revenue, good cash reserves and a handle on its debt, and that it expects this situation to continue. Especially if the economy enters recession, that’s an excellent signal for fundamental value. It suggests that this company can be a good long-term investment, regardless of current share prices.
Finally, dividend stocks have historically been an excellent hedge against inflation.
Dividend-paying stocks tend to make up an enormous portion of the stock market’s return during periods of high inflation. One analysis by Fidelity found that when inflation was at 5% in the 1940s, 1970s and 1980s, dividends made up 54% of the S&P 500’s overall returns. This is in large part because companies can adjust their dividend payments on a quarterly basis, letting them keep up with the changing value of money.
In an atmosphere of ongoing inflation, dividend stocks are historically a strong choice.
Where to Focus Your Attention
For active stock pickers who would like to pursue a defensive dividend strategy, Morgan Stanley recommends four key areas of investment:
- Industrials: Manufacturing and logistics firms are likely to benefit from increased infrastructure and defense spending, according to Morgan Stanley.
- Health care: Medical firms have tended to outperform the market in past recessions, and are poised to take advantage of new technologies.
- Consumer goods: Morgan Stanley expects these firms to raise consumer prices and recover well from high commodity prices over the past year.
- Global stocks: Investing in global high-dividend stocks can allow investors to diversify their portfolios and capitalize on the momentum in this area.
When you look for dividend stocks, be somewhat judicious. In particular, be careful of stocks with yields that are too high, Skelly advises. This can signal an imbalance between the stock’s share price and its dividend payments, suggesting high payments that the underlying business may not be able to sustain.
Also, look at the stock’s price-to-earnings (P/E) ratio. Despite concerns over bear market territory, investors are also worried that many of the market’s high-performing stocks may be overvalued relative to the company’s underlying earnings. In those cases, investors can often expect the stock to lose value, and to lose value particularly quickly in the event of a recession.
Many investors are worried about a recession in late 2023. To insulate your portfolio, Morgan Stanley recommends investing in dividend stocks to take advantage of their historic stability and potential for outsized returns in down markets. Active stock pickers who wish to pursue this strategy may consider dividend stocks in the industrial, health care and consumer goods sectors.
Dividend Investing Tips
- If you need help investing in dividend stocks or want more guidance when it comes to your whole portfolio, consider speaking with a financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Interested in dividend investing? You’ll want to familiarize yourself with how dividends are taxed. The exact dividend tax rate you pay varies by the type of dividends you have: non-qualified or qualified. Here’s everything you need to know about dividend taxes.
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