PrefBlog

The winner of the Charles Brandes Prize, awarded by the Brandes Institute, has been announced and is an excellent effort by Samuel M. Hartzmark and David H. Solomon titled The Dividend Disconnect:

We show that many individual investors, mutual funds and institutions trade as if dividends and capital gains are separate disconnected attributes, not fully appreciating that dividends come at the expense of price decreases. Behavioral trading patterns (e.g. the disposition effect) are driven by price changes excluding dividends. Investors treat dividends as a separate stable income stream, holding high dividend-yield stocks longer and displaying less sensitivity to their price changes. We term this mistake the free dividends fallacy. Demand for dividends is systematically higher in periods of low interest rates and poor market performance, leading to high valuations and lower future returns for dividend-paying stocks. Investors rarely reinvest dividends into the stocks from which they came, instead purchasing other stocks. This creates predictable marketwide price increases on days of large aggregate dividend payouts, concentrated in stocks not paying dividends.
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If investors are subject to the free dividends fallacy, viewing dividends as a distinct source of income, they should place a higher value on that perceived income stream when other options for income are less attractive. For an investor exhibiting the free dividends fallacy, perhaps the closest substitute for dividend income is from bonds. We nd that dividend demand is higher when the interest rate is low, consistent with the periodic payments from bonds appearing less attractive. In
the cross-section, demand is higher for stocks whose dividends are more stable, and whose dividends have increased in the recent past. In addition, the demand for dividends is lower when recent past market returns have been higher. In these times, the smaller predictable stream of payments from dividends is apt to appear less attractive compared with the large recent capital gains, if the two components are evaluated as separate alternative ways to make money on a stock.

I don’t agree with this bit:

Finally, if investors view dividend payments as being separate from the value of their position, they may not reinvest dividends into the stocks from which they came. This has been shown before for the case of individuals in Baker et al. (2007), who argued that dividends were financing consumption. We show that dividend reinvestment is also rare among mutual funds and institutions (similar to Kaustia and Rantapuska (2012) using Finnish data). As well as being more sophisticated than retail investors, most mutual funds and institutions lack the consumption motive of individuals, meaning that there must be other motives for their behavior. Using quarterly holdings, we examine how often dividend-paying holdings increase by approximately the number of shares that could be purchased with the dividend on the payment date (when reinvestment requires a non-trivial number of shares). We compare this to another benchmark for passive investing – holding exactly the same number of shares in the subsequent quarter, and leaving the dividend in cash or investing it elsewhere. We show that dividend reinvestment is only about 2.3% as common as zero holdings changes for the case of mutual funds, and 9.6% as common for institutional investors. If revealed preference is to be believed, the low level of dividend reinvestment implies that these investors have a desire to marginally reduce their portfolio weights by the exact amount of the dividend starting on the ex-dividend date. It seems more likely that these sophisticated investors are either not directly tracking which dividends correspond to which stocks for reinvestment purposes, or do not
care enough to maintain particular portfolio weights.

Portfolio cash flows are an excellent means to slowly rebalance portfolios. Any portfolio manager, good or bad, will have three categories of stocks: buy, hold, sell. When one of the ‘hold’ stocks pays a dividend, there is not necessarily any rational reason to reinvest the dividends in that issue; there will be at least some rationale to reinvest the dividend in one of the ‘buy’ stocks.

I’m also skeptical of this bit:

The disconnect between price changes and dividends also helps to unify a number of results that are puzzling under normal assumptions about returns. Baker et al. (2007) present evidence that individuals like to consume out of their dividends, consistent with the mental accounting distinctions between dividends and capital gains. Baker andWurgler (2004b) argue for a catering theory whereby investors have a general demand for dividends due to psychological or institutional reasons, though the psychology behind this is not discussed at length. The free dividends fallacy not only explains psychologically why dividends may be desirable, but also why the shifting attractiveness of capital gains and dividends can generate time-varying demand for dividends which rms respond to (Baker and Wurgler 2004a). Valuing dividends purely as an income stream can also help to explain the observed preference that older investors have for dividends documented in Graham and Kumar (2006) and Becker et al. (2011), and the fact that investors do not perceive the risk-reward tradeoff inherent in the change in leverage associated with a dividend, as shown in Welch (2016). An overall demand for dividends is consistent with Hartzmark and Solomon (2013), who document abnormally positive returns during dividend months linked to price pressure from dividend-demanding investors. Harris et al. (2015) show that mutual funds have a tendency to juice their dividend yield by trading in and out of dividend-paying stocks to increase the fund’s dividend yield at the expense of overall returns. These results all point to a generalized time-varying demand for dividends, but do not explain why dividends are desirable.

Prices are more volatile than dividends; it is therefore desirable, in a consumption situation such as retirement, to arrange one’s portfolio so that income is spent while the capital is untouched – this forms a part of ‘Sequence of Returns Risk’.

However, this bit is sobering:

Our results suggest that the free dividends fallacy is costly to investors because of the systematic nature of time-varying dividend demand. In addition to the direct costs and benefits associated with dividend paying stocks (such as taxes, trading costs and reinvestments), if investors buy dividend paying stocks when they are relatively over-priced due to a general demand for dividends, they will earn predictably lower returns. We estimate that investors buying dividend-paying stocks during times of high demand earn roughly 2-4% less per year in expectation. Thus an investor whose preferences for dividends cause him to shift into and out of dividend-paying stocks at the same time as other investors would lose a significant portion of the equity premium by doing so.

The big news today is that the Bank of Canada did not change policy:

The Bank of Canada today maintained its target for the overnight rate at 1 per cent. The Bank Rate is correspondingly 1 1/4 per cent and the deposit rate is 3/4 per cent.

Inflation has picked up in recent months, as anticipated in the Bank’s July Monetary Policy Report (MPR), reflecting stronger economic activity and higher gasoline prices. Measures of core inflation have edged up, in line with a narrowing output gap and the diminishing effects of lower food prices. The Bank projects inflation will rise to 2 per cent in the second half of 2018. This is a little later than anticipated in July because of the recent strength in the Canadian dollar. The Bank is also mindful that global structural factors could be weighing on inflation in Canada and other advanced economies.

The global and Canadian economies are progressing as outlined in the July MPR. Economic activity continues to strengthen and broaden across countries. The Bank still expects global growth to average around 3 1/2 per cent over 2017-19. However, this outlook remains subject to substantial uncertainty about geopolitical developments and fiscal and trade policies, notably the renegotiation of the North American Free Trade Agreement.

Canada’s economic growth in the second quarter was stronger than expected, and was more broad-based across regions and sectors. Growth is expected to moderate to a more sustainable pace in the second half of 2017 and remain close to potential over the next two years, with real GDP expanding at 3.1 per cent in 2017, 2.1 per cent in 2018 and 1.5 per cent in 2019. Exports and business investment are both expected to continue to make a solid contribution to GDP growth. However, projected export growth is slightly slower than before, in part because of a stronger Canadian dollar than assumed in July. Housing and consumption are forecast to slow in light of policy changes affecting housing markets and higher interest rates. Because of high debt levels, household spending is likely more sensitive to interest rates than in the past.

The Bank estimates that the economy is operating close to its potential. However, wage and other data indicate that there is still slack in the labour market. This suggests that there could be room for more economic growth than the Bank is projecting without inflation rising materially above target.

Based on this outlook and the risks and uncertainties identified in today’s MPR, Governing Council judges that the current stance of monetary policy is appropriate. While less monetary policy stimulus will likely be required over time, Governing Council will be cautious in making future adjustments to the policy rate. In particular, the Bank will be guided by incoming data to assess the sensitivity of the economy to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation.

This led to mutterings that the bank is dovish:

The Canadian dollar sank more than 1 percent against the U.S. dollar and investors pushed back bets on the timing of further interest rate increases from the central bank after Poloz, who left his benchmark rate at 1 percent, warned that the prior appreciation of the currency would dampen export growth and inflation.
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Implied odds of a December rate increase fell to one-in-three after the Bank stood pat, from almost 50 percent before the decision. The yield curve for Canadian Bankers’ Acceptances shows markets are pricing in a less urgent path for rate normalization, with the total amount of tightening expected in 2018 only modestly reduced relative to a month ago.
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Excess capacity in the labor market suggests little risk of inflation overheating in the near term, said Poloz, who highlighted involuntary part-time workers, subdued work force participation among youths, lower than expected hours worked and softness in wage growth as signs the economy has further room for improvement.

The Bank of Canada expects a broad-based pick-up in business investment to continue, with capital spending playing a larger role in driving economic activity. Policy makers raised their assessment of how fast the economy can grow without generating inflationary pressures, with Poloz later telling reporters that the revision was a conservative one.

PerpetualDiscounts now yield 5.30%, equivalent to 6.89% interest at the standard equivalency factor of 1.3x. Long corporates now yield a little over 3.95%, so the pre-tax interest-equivalent spread [in this context, the “Seniority Spread”] is now about 290bp, a slight [and perhaps spurious] narrowing from the 295bp reported October 18.

How about a good news drone story?

One company may be giving your local food delivery person some cause for worry, or atleast a run for his money. Project Wing, which is a drone delivery service project supported by the Google-owned Alphabet-X Lab, is now sending drones carrying burrito food orders to various parts of the Australian countryside.

We need this in Canada! Specifically, Toronto. Particularly, my place.

PerpetualDiscounts now yield 5.32%, equivalent to 6.92% interest at the standard equivalency factor of 1.3x. Long corporates now yield about 3.95% so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 295bp, a significant widening from the 285bp reported October 11.