Investors who rely on dividends for a large part of their income should prepare for significant dividend cuts and suspensions in 2020.
In recent weeks, stock markets around the world have crashed as a direct result of the coronavirus pandemic.
In most corrections and market crashes, dividend investors are able to shrug off paper losses and focus on what really matters; their reliable stream of dividend payments.
But in the current crisis that may not be so easy.
The limitations on free movement of people and goods being put in place to slow the spread of the virus will have (and are already beginning to have) a significantly negative impact on the ability of most companies to generate the cash they need to pay dividends.
So how bad could it get? Of course we don’t know, but history may provide us with a few clues.
S&P 500 dividend cuts during previous crises
Thanks to professor Robert Shiller we have data on dividend payments of the largest 500 US companies going back more than a century.
This is very handy as it covers a period with multiple world wars, pandemics, oil crises, recessions and depressions.
So let’s have a look at what sort of damage a major economic disaster can do to the combined dividend of 500 very large companies (I’ll refer to these 500 companies as the S&P 500, even though that index didn’t exist 100 years ago).
The chart above shows a nice trend, with dividends carried upwards by a mix of inflation, population growth and economic growth per person over the last century and more.
However, within this long upward trend there were many periods where the S&P 500’s dividend declined in both nominal and real terms, and some of the declines were quite severe.
- Post-World War One recession and the Spanish flu pandemic (1918-1926): Dividends decline by as much as 33%
- The Great Depression (1931-1937): Dividends declined by as much as 55%
- World War Two and related recessions (1937-1949): Dividends declined by as much as 48%
- Stagflation (1966-1990): Dividends grew in nominal terms, but thanks to high inflation they declined in real terms by as much as 25%
- Global Financial Crisis (2008-2012): Dividends declined by as much as 24%
So the combined dividend of the 500 largest US companies has decline, multiple times, by more than 20% to more than 50% over the last century.
Given that fact, is it reasonable to think that the coronavirus pandemic has the potential to be as damaging to the global economy and to dividends as previous world wars, pandemics, depressions and financial crises?
I think the answer has to be yes.
Dividend-dependent investors should prepare for the worst and hope for the best
I think it is entirely reasonable to assume that the current pandemic has the potential to cause very deep recessions in many countries and perhaps even a global recession.
I also think it’s reasonable to be prepared for dividend payouts from the S&P 500, the FTSE 100 & 250 and other major indices to decline by 50% or more, for at least a few months and possibly a few years.
And of course dividend declines could be much larger for individual companies, many of whom will suspend their dividends entirely and some of whom may go bust before their dividends are ever reinstated.
I’m no financial advisor, but if you depend on dividends for a significant part of your income then I suggest you do some scenario planning in which your dividend income declines by 50% in both 2020 and 2021.
And if you’re heavily exposed to companies that have lots of debt, weak profits and an inconsistent or nonexistent track record of growth, rather than companies with low debts, strong profits and a consistent track record of growth, then you may have to prepare for a significantly larger drop in income.
To benefit from the recovery you have to survive the downturn
While coronavirus is very bad, it is unlikely to be the end of civilisation or capitalism as we know them.
Eventually (hopefully within one year, probably within two years) the global economy, share prices, dividend payouts and life in general will recover.
But to benefit from the recovery, you have survive the crisis.
For dividend-dependent investors that generally that means:
- Having a cash buffer: Shares or other investments sold at low prices to generate a cash income cannot benefit from the recovery
- Cutting expenses: Removing unnecessary expenses so you don’t burn through your cash buffer too fast
- Not panicking: Not selling in a blind panic even if the stock market declines by 50% or more
I’m sure there are other more nuanced guidelines for surviving a global crisis, but those are the big ones for me.
How big should your cash buffer be?
It mostly depends on the ratio between your fixed expenses and your investment income.
If you have fixed expenses of £20,000 per year and receive a dividend income of (about) £50,000 per year, then you probably don’t need much of a buffer. You should be able to sail through a 50% dividend decline with no major problems.
On the other hand, if you need every penny of your dividend income to cover the basics and you also work part-time to top that up, then you should probably have a bigger buffer, relatively speaking.
But how big is big enough?
That’s for you to decide, but here’s a handy rule of thumb from the Money Advice Service:
“A good rule of thumb to give yourself a solid financial cushion is to have three months’ essential outgoings available in an instant access savings account. So if you lose your job, for example, it’ll help buy you three months to find a new one.”Money Advice Service – Emergency Savings
If you want more than three months as a buffer and can afford it then great, but I think having a buffer that can cover three months’ of fixed expenses is a good minimum.
If you’re looking for some additional information on how to prepare for a recession, or what to do when the stock market collapses, here are a couple of good posts from the Monevator website: