Equity markets are near all-time highs. Despite several major headwinds, investors continue to pour money into a market backed by strong earnings, major AI investment and an overall positive outlook on the economy. This market optimism, with some caveats, has been the prevailing narrative for years. However, investors don’t share the same level of confidence when it comes to dividends.
A strong economy should in theory lead to bumper dividend payouts, but for over a decade, traders have underpriced potential dividend earnings.
Since 2015, there has been a persistent gap between market-implied dividend expectations and the actual payout for S&P 500 companies. Outside of 2020 and the Covid pandemic, markets have consistently underestimated dividend payouts. The same pattern occurs for Russell 2000 and Nasdaq 100. Since dividend futures were launched for those indices in 2022, investors only overestimated Nasdaq 100 dividends once.
Their pessimism extends out into the 2030s. Trading in the dividend futures market is currently pricing only modest nominal growth in dividends and negative real growth when adjusted for inflation.
Investors are simultaneously optimistic about future earnings and share price but are predicting declining payouts in relative terms.
Share buybacks, the alternative method of returning cash to investors, doesn’t seem to be the answer. Since a change in dividend tax rates in 2003, payout ratios for S&P 500, S&P 400 Midcap and Russell 2000 as a percentage of total corporate profits have sat at around 20% as an aggregate of corporate profits. Post-pandemic it’s been even more stable.
Corporate profits could stabilise, leading to stagnant or even declining dividends, but record high stock prices indicate few actually believe that. And even if that was the case, companies typically slash buybacks and preserve dividends during economic downturns.
The persistent discount observed in annual dividend index futures may have less to do about the long-term health of corporate earnings and the U.S. economy and more about the structural mechanics of the equity derivatives market.
There is a diverse set of investors that trade equity derivatives, from delta-one trading desks to multi-strat funds. Historically, for dividend futures and options, the investor base was limited to structured product desks. The market is traditionally where they offload dividend risk as a by-product of building their prepackaged investment. Over the past decade, new participants such as hedge funds, asset managers, market makers and insurers entered, helping build open interest and liquidity.
However, the persistent gap between implied and actual dividends suggests the curve remains anchored by the hedging requirements of structured product desks.
In short, it’s still a buyers’ market.
Finding the natural buyer
Dividends have been partly side-lined over the past decade. The growth of the S&P 500 has been led by tech companies who traditionally do not have high dividend yields. Investors have also focused on share price over the steady gains of quarterly or semi-annual payouts.
Dividend rates are also in a state of flux. Nvidia surprised the market recently by raising their dividend from 1 cent to 25 cents, leading the dividend future and options curve to jump several basis points. At the same time, the impending IPOs of several AI giants are pushing expectations lower in the long-term.
But there is an opportunity for the disciplined investor. With after-tax corporate profits becoming a larger part of the economy. Earning seasons are becoming a macro-economic event on par with employment figures, inflation and quarterly GDP results. In the last three-and-a-half decades, corporate profits have steadily grown from 5% to a record high 11.5% of GDP.
For more complex strategies, dividends present a potential 1-2% annual return that would roughly be on par with corporate debt in terms of risk. The disconnect between equities and dividend expectations offers a compelling relative-value opportunity: the chance to capture the underlying yield of the S&P 500, Nasdaq 100, or Russell 2000 at a price that seems to ignore the very optimism driving the cash indices to new heights.
