July 5, 2016

Positive results of the U.S.-based bank stress tests were announced, enlivening the dividend investment community that had been awaiting the results given the potential to impact dividends and stock prices of banking institutions for 2016. Stress testing is designed to determine whether a financial institution is capable of withstanding some type of economic downturn, making it a natural indicator of company health. The Federal Reserve has indicated that all 33 tested banks have sufficient capital on reserve in order to weather losses in a recession. In the qualitative tests, all 24 banks in the S&P 500 passed and are now able to raise their dividends. As a firm solely focused on divided growth investment solutions, Reality Shares has been closely watching forecasted dividend momentum surrounding stress testing for its impact on the overall market dividend growth rate. Stress testing directly impacts dividends, as financial institutions failing stress testing are prevented from paying out dividends or any type of capital to their shareholders.

Stress testing began in the aftermath of the Great Recession as a result of the financial crisis that brought down and threatened several financial institutions including AIG, Countrywide Financial and Lehman Brothers. In its aftermath, the U.S. Federal Reserve created the Comprehensive Capital Analysis and Review to monitor financial institutions in the hopes of preventing any future bailouts. These tests have come to be known as CCAR or stress-tests, and today determine whether a company over $10 billion in assets can go through a sort of worst-case downturn scenario, weather such difficulty and survive. As of June 30, 2016, the results of the stress tests were announced, with all U.S.-based banks passing, though Morgan Stanley passed conditionally. Two foreign banks, Deutsche Bank and Santander, failed the qualitative portion of the stress tests due to what were called “broad” weaknesses.

Delving Deeper into the Dividend Growth Investment Insights of Stress Testing

While banks might complain about the difficulty and cost of performing annual stress tests, the tests have provided valuable insight to investors and especially dividend growth investors. Banks seek to keep or increase their dividends even when it may be financially restrictive, as failing to do so reflects very poorly upon the company and its management. Also, being prevented from paying a dividend whatsoever seems unthinkable to most company management teams, as investors in companies under that much financial distress may choose to sell positions or even move to replace underperforming executives.

Bank balance sheets have only improved since the Great Recession, meaning if allowed by the Federal Reserve, many banks could likely be looking to increase their dividend after the stress test announcement. This historically has buoyed stock performance, as we have all seen the research showing that dividend growers significantly outpace non-dividend payers. Conversely, companies or banks that cut or eliminate dividends typically see selling pressure and have historically underperformed (Source: Ned Davis Research, Reality Shares Research; January 1, 1972 – December 31, 2015).

Supportive News for the Dividend Growth Rate

The positive stress test results could mean there is still much room for dividend growth in the financial sector, resulting in the potential positive impact to the overall market dividend growth rate. The two banks with perhaps the most potential to significantly impact overall dividends are Bank of America and Citigroup. Prior to the Great Recession, Bank of America paid a dividend of $0.64 per share. When factoring in its reverse stock split, Citigroup paid $5.40. More recently however, both banks have paid dividends as low as just $.01, largely stemming from their difficulties in passing annual stress tests. Both banks passed stress tests in June, immediately announcing dividend increases afterward. Bank of America announced a 50% dividend increase to 7.5 cents a share while simultaneously buying back up to $5 billion in stocks. Citigroup indicated it would significantly raise its dividend while buying back up to $8.6 billion of its own stock. These two dividend actions alone impacted the S&P 500 dividend by 0.56% (Source: Reality Shares Research).

Among the other 22 banks listed in the S&P 500, all passed and another 18 immediately announced their intention to increase their dividend. In fact, 17 of the 20 total banks announcing dividend increases exceeded analyst expectations for dividend growth, showing even more potential strength in the financial sector. Because the sector is historically one of the largest payers of dividends in the S&P 500, these positive stress test results could have a much larger than expected impact on the overall dividend growth rate.

14 of the 24 banks in the S&P 500 that underwent stress tests were paying dividends at or below pre-recessionary levels, meaning those that pass will potentially be able to grow their dividend.

Room for Dividend Growth in Financials

As of the end of June, the financial sector only paid about 16.36% of the dividend in the S&P 500, with companies in the financial sector paying an average dividend yield of about 2.25% (Source: S&P Dow Jones Indices; June 30, 2016). While these number are on par with the overall index, the financial sector has previously paid as high as 30% of the S&P 500’s dividend, potentially leaving room for growth.

Investors looking to take advantage of this potential increase in the dividend growth factors can do so with DIVY, an exchange-traded fund (ETF) designed to isolate and access the dividend growth rate. DIVY was created as a low volatility absolute return strategy that allows investors profit from any greater than expected dividend growth in the S&P 500. DIVY is also uncorrelated to stock prices and the daily movements of the stock market, making it ideal for investors looking for some intended stability and diversification in their portfolios.

Reality Shares offers the DIVY ETF that participates in the dividend growth rate. Visit our ETF pages or call (855) 595-0240 to find out more.

S&P 500: A broad stock market index of 500 large companies based on market capitalization.Dividend Yield: A ratio that indicates how much a company pays out in dividends each year relative to its share price.

Diversification does not eliminate the risk of experiencing investment losses.

DIVY seeks to produce long-term capital appreciation. There are risks involved with investing including the possible loss of principal. Investments in swaps, options, and futures and forward contracts are subject to a number of risks, including correlation risk, market risk, leverage risk and liquidity risk, which may negatively impact the Fund’s investment strategy and could cause the Fund to lose money. Please review the prospectus for other important risks regarding the Fund, as each of these factors could cause the value of an investment in the Fund to decline over short- or long-term periods.

Unlike more traditional dividend ETFs, the Fund does not seek returns based on appreciation in the stock market price of equity securities, return dividend income, or invest in dividend paying stocks. The Fund does not invest in equity securities. The S&P 500 Index is represented by equity securities, whereas the Fund invests in a series of dividend swap contracts on the S&P 500 index.