Source: S&P Dow Jones Indices

The long-term performance of a portfolio of dividend-paying stocks has been discussed in detail in investment literature as a sound, long-term investment strategy. The above table published quarterly illustrates the point quite clearly. It shows an investment strategy based on dividend-paying stocks not only has had superior returns, but these returns have been achieved with exceptionally low volatility when compared to other strategies.

But the performance could be improved if investors considered the impact the business cycle has on a portfolio of dividend-paying stocks as represented, for instance, by the two ETFs NOBL and DGRO.

Source: The Peter Dag Portfolio Strategy and Management

Phase 1 and Phase 2 of the business cycle are characterized by the business decision to replenish inventories following the cuts they had to make in Phase 3 and Phase 4. To replenish inventories, businesses must buy raw materials, hire more workers, and borrow money to finance the operation, improve, and expand capacity.

The virtuous cycle (positive feedback) of hiring, producing, and borrowing strengthens the economy. In Phase 2, business activity is strong as the economy is growing at an above average pace. This is the time in which commodities rise rapidly, accompanied by rising wages and interest rates. In other words, inflation is now becoming an issue.

As business fills up capacity, productivity declines, placing upward pressure on labor costs and hindering profitability.

When consumer demand wanes due to the decline in purchasing power, businesses are forced to cut inventories to match slower sales and to protect profitability. Raw material purchases are reduced, workers are laid off, and borrowing is cut. These decisions bring detrimental results (negative feedback) throughout Phase 3 and Phase 4.

At the end of Phase 4, because of the reductions implemented by business, commodities, inflation, and interest rates are declining. Productivity improves because of lower capacity utilization, and profitability hedges higher. The improvement in purchasing power due to the decline in inflation begins to stimulate demand. Businesses realize they must replenish inventories, and thus Phase 1 starts all over again.

Investors can benefit as the business cycle moves through its phases. Phase 1 and Phase 2 are characterized by increases in the price of most assets: energy, metals, and most commodities. Rising interest rates are also a feature of this period. Investment in cyclical stocks is particularly attractive during these phases. During Phase 3 and Phase 4, on the other hand, defensive sectors such as staples, REITs, healthcare, utilities, and bonds tend to outperform the market.

The iShares Core Dividend Growth ETF (DGRO) seeks to track the investment results of an index composed of U.S. equities with a history of consistently growing dividends. The performance of this ETF confirms the results shown in the first chart by S&P 500 Dow Jones Indices. It is interesting to note, however, this ETF is particularly sensitive to the trends of the business cycle.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management.

To recognize its sensitivity to the business cycle, we have prepared the above chart. The chart shows three panels. The upper panel shows the price of DGRO. The middle panel shows the relative performance of DGRO compared to the metals and mining stocks index (XME). This is done by computing the ratio for DGRO divided by the SPY. 

The ratio rises when DGRO outperforms XME. DGRO underperforms XME when the ratio declines. The lower panel shows the business cycle indicator. Although DGRO has a solid long-term performance, the ETF is particularly attractive when the business cycle declines, reflecting a weakening economy. 

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management.

The above chart shows how the same relationship discussed for DGRO applies to the ETF NOBL - an ETF focusing on companies within the S&P 500 that have raised their dividends for at least 25 consecutive years. 

The chart shows three panels. The upper panel shows the price of NOBL. The middle panel shows the relative performance of NOBL compared to the metals and mining stocks index (XME). This is similarly done by computing the ratio for NOBL divided by SPY. NOBL outperforms XME when the business declines, reflecting a weakening economy. On the other hand, XME outperforms NOBL when the economy strengthens and the business cycle rises.

Key Takeaways

DGRO and NOBL are superb long-term investments as suggested by the data showing a strategy based on an investment in dividend aristocrats produces above average returns with low volatility. The investment results could be further enhanced by investing in DGRO or NOBL when the business cycle declines, and investing in XME when the business cycle rises.