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Over to The Veteran today and he's asking... Dividends or Growth...?

What rate of interest are you getting on any cash you hold at the moment?

Zero percent or close to it I'll bet.

Well, I am afraid to say that it’s far worse than that.

Let me show you what I mean...

Consider the chart below which tracks the rate of inflation in the USA and plots that over the yield of the 10-year Treasury note. The differential between the two values is the real rate of return or the reward that bondholders receive for holding 10 year US govt debt.

If you haven’t worked it out yet the return is negative!

In fact, it’s deep underwater at almost -3.78%

That means that for every $100 you have invested in US 10-year bonds you can expect to lose almost$4.00.

(it's a similar story in all developed economies)

What’s worse still is that that isn’t the figure that you can expect to lose over the 10-year lifetime of the bond, it’s the annual figure.

You can literally see your money and its purchasing power evaporating in front of you....

Now, there are a multitude of reasons why people want to hold bonds or keep money in cash.

By the way, anyone holding cash isn’t even getting the +1.5% on their deposit that 10-year bondholders get, so it's an even worse position...

What’s needed is some sort of inflationary hedge and the need for a hedge helps to explain why retail traders have such a big allocation to equities right now.

For example, private clients at Bank of America have 64.8% of their money in stocks right now, an allocation that the bank describes as being very high.

Why is so much money in stocks?

Well just look at the returns that stocks have generated over the last three years:

In 2019 the S&P 500 returned +31.49%, in 2020 +18.40% and so far in 2021 +15.92%.

If your money is growing at that kind of rate then most likely you feel that you can (reluctantly?) shrug off +4% or +5% inflation, particularly if you let your money ride and have seen stock market growth compounded over the best part of three years.

But what if you couldn’t rely on those returns to bail you out going forward?

Why would you say that? How could that come about?

Well, the honest answer is quite easily. Although the rising tide of QE has lifted all the ships in the equity market, growth stocks have risen the most.

For example, the S&P 500 information technology sector has returned more than +109% over the last three years and it contains the mega-cap stocks that have the most influence over the broader S&P 500 index.

Now, unfortunately, it’s those very same tech/growth stocks that are the most sensitive to changes in interest rates, whether real or anticipated.

S&P DJ indices kindly break down factor returns on a monthly basis and we can dip into that data to illustrate this point.

During September when investors saw implied interest rates move higher and anticipated further rate rises in future, growth stocks sold off -5.8% and the more concentrated pure growth factor by -5.3%.

Now, let’s be clear September, was a rotten month for stocks across the board but the fact the strongest stocks were undermined the quickest should give us pause for thought.

So if we can’t really on growth stocks to fend off the effects of inflation, where can we look?

Well, one of the reasons that investors owned bonds for was income.

Owning an asset that pays you a return for doing so is one of the cornerstones of capitalism and growing your wealth. However, it’s not just bonds that pay you to own them. Stocks do too.

And there are a number of stocks that have been consistent dividend payers and growers, and we can feel confident that they will be able to maintain that track record into the future.

This chart from S&P Dow Jones Indices shows the 1 year performance of the S&P 500, the S&P 500 Growth Index, the S&P Dividend Aristocrats and the S&P 500 High Dividend index over the last year.

The high dividend index is the clear winner having returned 42.18%, almost doubling the return of the dividend aristocrats index.

If we look at the constituents within that index we find that the top 10 holdings are energy companies and financials (just the kind of stocks that should do well in a period of rising interest rates and rising energy prices)

Of course, as we know there is no such thing as a free lunch so what's the catch?

Many of the stocks in the S&P 500 High Dividend index have a high dividend payout ratio.

In some cases, they are even paying out more than they earn either by dipping into reserves or by taking on debt to make the dividend payment, which may not be sustainable over the long term, particularly if energy prices reverse course over the next 12 months.

The dividend aristocrats are a group of stocks that have an unblemished dividend record however and so one could easily create a strategy where the larger part of your investment went into dividend aristocrats and a smaller portion was placed into the more speculative High Dividend index stocks.

Next time out, we'll be looking for stocks that offer both capital return AND dividends...

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