It’s known as the most exciting two minutes in sports.
Held annually since 1875, the Kentucky Derby is a famed one-and-a-quarter-mile horse race.
California Chrome, which had won its previous four starts, was this year’s Derby winner.
The result came as a relief for many, as the winner was the overwhelming favorite, indicating an accumulation of wagers on the horse.
There was likely a significant amount of money hinging on just that outcome, too, considering that Kentucky Derby wagering activity totaled $185 million in 2013.
This may not come as a surprise, since gambling is ingrained in our culture. From sports betting and casinos, to raffles and lotteries, there’s no shortage of ways to make risky bets around us. The allure of easy money is certainly powerful, and the thrill from winning can be just as addictive as drugs.
Now, as you know, an affinity for gambling also pervades the financial markets.
But the stakes are simply much higher.
And this year, the market has been especially effective at punishing the gamblers (i.e., emotional speculators) and rewarding disciplined investors.
Consensus Has Been Wrong
The S&P 500 has plodded to a 2.0% total return so far in 2014.
Of course, considering the S&P’s 32.4% windfall in 2013, the market is due for a bit of sideways action. So any increase is actually pretty decent.
Still, there seems to be a lot of angst in the financial markets.
First of all, many asset managers and financial institutions have been caught off guard by declining bond yields. Indeed, Treasuries have been one of the best-performing asset classes in 2014 as the U.S. 30-year rate has declined from 3.96% at the start of the year to 3.33% now (bond prices and yields move inversely).
Those actively betting on higher rates have been dead wrong.
Oh, and if you’re a speculator who has been chasing momentum stocks and piling into small caps (two very popular trades in the first quarter), you’ve had a decidedly bad year thus far.
As you can see, the S&P 600 Small-Cap Index and the iShares MSCI USA Momentum Factor ETF (MTUM), which tracks the performance of U.S. large- and mid-capitalization stocks exhibiting relatively higher momentum characteristics, both peaked in early March.
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Now, let’s take a look at how dividend stocks have performed.
The Power of Dividends
The S&P 1500 Index is a broad measure of the U.S. equity market, and includes large-, mid- and small-cap stocks. There are approximately 1,000 dividend-paying stocks in the S&P 1500.
As you can see from the following chart, dividend payers have outperformed non-dividend payers so far in 2014 on a total return basis (includes dividends):
Since we already know that dividend stocks have a history of outperforming, these results shouldn’t be too surprising.
However, when we narrow our focus to the period after March – when momentum stocks and small caps started to take a turn for the worse – the superiority of dividend-paying stocks is even more striking…
Dividend stocks have outperformed their non-dividend-paying peers by nearly 6% since March 6.
So, while frustration spreads as high-flying trades become grounded, investors who have stayed disciplined and shown an unwavering belief in the power of dividends have been able to dodge the fallout.
Bottom line: Following the herd into popular, crowded trades solely because of rising prices or a fear of missing out is akin to gambling. However, by maintaining discipline and basing our decision making processes on high-probability outcomes, we can focus on building wealth over the long term.
The trends in 2014 not only serve as lessons, but also warning signals.
Small-cap stock underperformance – along with declining Treasury yields – indicates waning risk appetite, which is being masked by equity indices putting in fresh all-time highs.
These red flags tend to occur at major market inflection points.
Safe (and high-yield) investing,
Alan Gula, CFA