Dividend Stocks Starting To Lose Their Luster

Volatility has pulled back recently with the VIX inching down to near the 20 level. Still, daily swings have been bigger than normal this year—2022 is pacing to be the year with the fifth highest average VIX level since 1990, according to data from Seth Golden. Expect volatility to continue to be elevated through this uncertain earnings season and ahead of the U.S. mid-term elections. History shows that significant S&P 500 dips can happen during the third quarter of year two of the election cycle.

Volatility Running High In 2022

Source: Seth Golden

Amid all that volatility, investors have found some solace in dividend stocks. Consider that the ‘high dividend yield’ factor is the strongest so far in 2022. Firms that have a history of paying out steady dividends are sometimes seen as more reliable than those reinvesting all cash into their business. What hasn’t been working this year are risky IPO stocks, growth companies and some small-cap areas.

YTD S&P 500 Factor Relative Performance

Source: Koyfin Charts

Honing in on dividends, it’s important to recognize that not all dividend stocks are created the same. According to research from WisdomTree ETFs, the so-called “2nd Quintile” has historically been the best niche to park your dividend allocation. Quintile 2 is simply the group with the second-highest yield (Quintile 1 stocks are the highest of high yielders, which tend to be overly risky). The second quintile usually houses companies with the right balance of a high payout rate without venturing too far up the risk spectrum.

Risk & Return Dividend Winner: Second Quintile

Source: WisdomTree

I found that research from Bank of America supports WisdomTree’s conclusion. The highest Sharpe Ratio among the five dividend groups is decidedly Quintile 2. Right now, that group of stocks yields from 2.46% to 3.49%, according to BofA. Performance-wise, Quintile 2 has beaten the Russell 1000 equal-weight index over the 3- and 5-year periods and since tracking began in 2010.

BofA: Quintile 2 Stands Out

Source: BofA Global Research

How can dividend-focused investors play this long-term, evidence-based trend of solid risk-adjusted returns from the second highest yielding quintile of U.S. stocks? In a note published last year, BofA addressed this question I posed to them: What ETF best tracks Quintile 2?

The answer: Vanguard High Dividend Yield Index Fund ETF Shares (NYSE:VYM). The ETF’s beta to Quintile 2 and its overall performance best replicates BofA’s screen.

The Dividend Play: VYM

Source: BofA Global Research

The Technical Take

As the growth style has rebounded sharply since the S&P 500’s mid-June low, value and dividend themes have struggled on a relative basis, however. While VYM has bounced from under $100 to about $104 at the high last week, I see resistance around that snap-back spot. Support is seen at the pre-pandemic highs in the mid-$90s.

VYM Technical Chart: Testing Resistance, Support at the Early 2020 Highs:

Source: Stockcharts.com

I also worry about positioning and sentiment in the near term with dividend-focused investing themes. The latest Bank of America Global Fund Manager Survey suggests defensive sectors are crowded. The report published last week shows the utilities, staples and healthcare sectors are the most overweighted by portfolio managers since May 2020.

Positioning Suggests Too Much Optimism In Defensive Areas

Source: BofA Global Research

The Bottom Line

I like the idea of having a reasonable long-term allocation to dividend stocks, but dividends alone should not be a reason to invest. Instead, taking a total return approach is wise. For that slice of your portfolio, however, owning something like VYM might make sense, given its exposure to what has worked historically – owning high-yield stocks, but not overly risky ones. Near term, I see downside risks to VYM considering the technical picture and positioning and sentiment.

Disclaimer: Mike Zaccardi owns VYM but none of the other securities mentioned in this article.