AI Ascendancy: Dividend Stocks Lose Luster as Tech Takes Center Stage

In the stock market, nothing remains the same for long. Last year, shares of companies offering generous dividends were among the most sought-after investments. Fast forward to the present day, and the allure of these income-generating stocks has waned significantly. During the bear market of 2022, investors flocked to dividend-paying stocks, seeking a consistent stream of cash. However, the current landscape has shifted dramatically towards growth-focused tech stocks, especially those that are central to the burgeoning artificial intelligence (AI) boom. These stocks do not typically offer dividends, but investors are banking on their potential for sizeable profits down the line.

In fact, S&P 500 stocks that do not pay dividends have collectively advanced about 18% this year, as per Ned Davis Research. In contrast, the income-generating companies have only managed a modest increase of around 4%. This is the poorest first-half performance for dividend payers relative to nonpayers since the aftermath of the 2008 financial crisis. At present, about 400 of the companies listed in the index offer dividends.

As 2023 kicked off, many investors and strategists were expecting a rerun of last year, when concerns over the Federal Reserve’s aggressive interest rate hikes sent tech and other growth stocks plummeting. But the scenario played out differently, as these stocks resumed their steady climb. The reason? Investors are banking on AI as a revolutionary force in computing.

The Nasdaq Composite ended the first half of the year up by a whopping 32%, while the S&P 500 rose by a respectable 16%. Leading the pack were growth stocks like Meta Platforms (formerly Facebook) and Tesla, both of which more than doubled in value. Retail giant Amazon.com also made significant strides, adding 55% to its value.

However, it would be naive to assume that these impressive gains guarantee a rosy future. The rest of the year is shrouded in uncertainty. The Federal Reserve continues to insist on raising interest rates. There is a general consensus among investors and analysts that the economy is slowing down. And the market’s rally has been relatively narrow, led by a handful of mega-cap tech stocks.

In the upcoming holiday-shortened trading week, all eyes will be on the June jobs report due on Friday and the May trade deficit numbers on Wednesday. These will be key indicators that could hint at the market’s trajectory.

“Economic growth has been positive but low, so investors have piled into a few companies that they think can deliver the growth,” observes Ed Clissold, chief U.S. strategist at Ned Davis Research. “People aren’t buying AI stocks because they’re excited about their dividend.”

The underperformance of dividend-paying stocks can be partly attributed to the sharp declines in regional bank stocks and a pullback in energy stocks, both sectors that led markets in 2022. For instance, shares of Zions Bancorp have declined by 44% this year on a total return basis, while Comerica and Citizens Financial Group have seen drops of 35% and 32%, respectively.

There’s another twist to the story: For the first time since the 2008 financial crisis, dividend-paying companies are competing with rising yields on ultra-safe government bonds. The added risk of owning stocks, especially given the possibility of a business downturn in a potential recession, does not seem worth the extra yield to many investors.

The evidence is clear: investors have been withdrawing funds from U.S. mutual and exchange-traded funds that focus on dividend-paying stocks for seven of the past nine weeks, as per LSEG Lipper data. This year, these funds have posted net outflows of about $4 billion, a stark contrast to last year’s record inflows of almost $70 billion.

Mark Hackett, chief of investment research at Nationwide, observes, “This year has been ultra-large tech and everything else. The first half of this year has been a ‘get me into the large tech names at any price.’”

He further suggests that investors buy shares of companies with strong balance sheets and robust cash-flow generation. This advice seems particularly apt at a time when investor enthusiasm is centered around AI and other tech stocks that promise growth over dividends.

Some tech giants, however, do offer dividends. Nvidia, a graphics chip maker leading the AI revolution, boasts a 0.04% dividend yield. Its shares have nearly tripled this year. Apple, which has seen its shares climb about 50% to new highs, offers a 0.5% yield. Chip maker Broadcom, on the other hand, has a yield of 2.2%.

It is important to note that the pendulum could swing back. Historical data from Ned Davis Research shows that dividend-paying stocks tend to outperform during economic slowdowns. The Fed’s interest-rate increases continue to be a source of worry, with fears that they could tip the economy into a recession. In such a scenario, defensive companies, known for their hefty dividends, could regain their appeal. After all, consumers prioritize spending on utilities, household goods, and medical expenses over discretionary items during downturns.

Vivian Hairston, director of portfolio management at Huntington Private Bank, explains this trend succinctly: “We’re going to continue to use those products—we’re going to continue to buy toilet paper. On the healthcare side, if we have medicine, we’re going to continue to buy that.” Hairston has increased her exposure to consumer staples and healthcare stocks in some strategies.

However, tech stocks could be especially vulnerable in the event of a recession, given their elevated trading levels. Nvidia trades at 47.2 times its expected earnings over the next 12 months, while Meta and Tesla trade at 21.1 times and 62.7 times earnings, respectively. In comparison, the S&P 500’s multiple is 19.

Paul Baiocchi, chief ETF strategist at SS&C ALPS Advisors, highlights a crucial point: “The bulk of your total return from your stock market portfolio has come from compounded dividends over time, much more so than the actual price appreciation of the stock market.” He adds, “We don’t think that the first six months of 2023 has necessarily altered that overall outlook for dividends going forward.”

In conclusion, while the first half of 2023 has seen investors gravitate towards AI and other tech stocks, the future may bring a resurgence of interest in dividend-paying stocks, especially if economic conditions take a turn for the worse. Despite the current euphoria around AI, it’s crucial to remember that investing is a long-term game, and the consistent returns offered by dividend-paying stocks can still play a pivotal role in portfolio growth