The S&P 500 is not at a new all-time high yet, but the S&P 500 is. 

How's that for a paradox? 

The clarification boils down to the distinction between the S&P 500 Price Index and the S&P 500 Total Return Index.  The former does not include dividends, but the latter does.

Hence, the S&P 500 Price Index is not a new all-time high, but the S&P 500 Total Return Index is.

This is not a small point.   Dividends make a distinct and positive difference for investors.  In fact, the S&P 500 Total Return Index has outperformed the S&P 500 Price Index every year for the last 20 years.

That is a coy, but nonetheless accurate, way of saying that it pays for long-term investors to embrace total return strategies, particularly in low-return environments but really in all environments as the chart below shows.

Some Tax Hike Relief

In our 2013 Market View, we indicated that we saw value in total return strategies this year.  That statement had as much to do with the potential for a low-return environment in 2013 as it did with historical precedent.

We made that statement on December 17 before we knew the fate of the dividend tax, which was set to revert to higher ordinary income tax rates for all shareholders if the Bush-era tax cuts were allowed to expire.  That meant a rate as high as 39.6% for the highest earners before an additional 3.8% surcharge to help pay for the Affordable Care Act.

In the (bitter) end, it was agreed by Congress to make the low income tax rates permanent for all individuals earning less than $400,000 and all households earning less than $450,000.  The income tax rate for earners above those respective thresholds increased from 35% to 39.6%.

The good news for investors in dividend-paying companies is that the dividend tax was left unchanged at 15% for households earning less than $450,000 (the 3.8% surcharge for the Affordable Care Act, however, will apply to dividend income for households earning more than $250,000). 

Furthermore, the dividend tax was increased to just 20% for households earning more than $450,000.  With the specter of a 39.6% dividend tax rate looming large, it was a cause for celebration that the highest dividend tax rate was capped at just 20%.

That set a good tone for dividend payers and the equity market overall entering 2013.

Something Beats Nothing

What things look like exiting 2013 is the great unknown, but what has been proven through history -- during wars, recessions, expansions, and geopolitical crises -- is that it literally pays to own dividend-paying companies.

Dividends are an income stream that can be reinvested in the stock or used for spending purposes. 

Companies that don't pay dividends may have higher growth rates and higher returns in any given year, but price appreciation is the only income inducement for investors.  If those stocks go down in price, there isn't an offsetting dividend payment to help lessen the loss.   

That's not to say it is always all good with dividend-paying companies.  Their stock prices can, and do, go down in material fashion when disappointing developments occur.  The key point is that dividend-paying companies still produce income for investors even when the stock price goes down.  And getting something beats the alternative of getting nothing.

This is a point that has started to resonate for investors given the paltry yields on Treasury securities and the increasing need for other, higher-yielding income alternatives for an aging population.  The current dividend yield of 2.34% for the S&P 500 is 50 basis points above the current yield on the 10-year Treasury note.

Within the S&P 500, there are currently 403 companies issuing dividends.  That is the highest number of companies paying a dividend since 1999.  The table below shows a breakdown by sector.

What It All Means

Given the limited total return prospects for US Treasuries, which are facing heightened interest rate risk at their current price levels, there is a good basis for long-term investors pursuing total return strategies to favor dividend-paying companies.  Other factors to consider include the following:

• The coupon rate on long-term Treasuries is fixed whereas dividends increase over time.
• Dividend income in tax-deferred accounts goes untaxed until it is withdrawn.
• US companies will be looking for ways to maintain their shareholder base with the retirement of the baby boomers.  Dividends will remain an important tying factor for that demographic, which will be seeking yield in a bid to stay ahead of inflation.
• US companies are sitting on piles of cash built up by record profits and strong cash flow growth, yet the dividend payout ratio is 35% versus a 20-year average of 46%. That depressed level has coincided with an increase in share buybacks, but clearly there is ample room to boost payout ratios. 
• With rising demand to bolster shareholder value in a potentially low economic growth, low investment return environment, company boards are apt to stay focused on paying, and raising, dividends in the wake of continued earnings growth.  

The US equity market has gotten off to a fast start in 2013.  The S&P 500 Price Index is up 4.19% since the start of the year.  According to Standard & Poor's, though, the S&P 500 Total Return Index is up 4.28% (every little bit helps).

Mindful of the prevailing belief at this juncture that the economy will see renewed growth momentum in the second half of the year and the thinking that there will be a great rotation out of bonds and into stocks, we can understand why investors would turn more to non-dividend payers in the pursuit of outsized price appreciation.

High beta stocks may be where the trading glory lies, but as the charts above show, dividend-paying stocks are where long-term investment outperformance is rooted.

--Patrick J. O'Hare, Briefing.com