Are Dividends Dead - Babson College



Do Dividends Matter more in Declining Markets?

Kathleen Fuller

Terry College of Business, University of Georgia, Athens, GA 30602

Michael Goldstein*

Finance Department, Babson College, Babson Park, MA 02457

October 26, 2004

Abstract

Using S&P 500 monthly returns as a proxy for market conditions, we find that dividend-paying stocks outperform non-dividend-paying stocks by more in declining markets than in advancing markets, implying that investors asymmetrically prefer dividends in down markets. These results are robust to risk adjustments using the CAPM, size and book-to-market quartiles, volume, the Fama-French three-factor model, and Fama-McBeth style regressions. Our results also suggest that is the existence of dividends, and not the level of the dividend, drives returns’ asymmetric behavior relative to market movements. We conclude that a signaling theory explanation is more consistent with our results than a prospect theory explanation.

JEL Classification Code: G35

Keywords: Dividend policy, asymmetry, market movements

*Corresponding author: Michael Goldstein, Finance Department, 223 Tomasso Hall, Babson College, Babson Park, MA 02457-0310 tel: (781) 239-4402. fax: (781) 239-5004 email: Goldstein@babson.edu. We thank Deepak Agarwal, Jeff Bacidore, Jennifer Bethel, Wayne Ferson, Paul Irvine, Jon Karpoff, Gautam Kaul, Laurie Krigman, Marc Lipson, James Mahoney, Donna Paul, Tyler Shumway, John Scruggs, and Chris Stivers. Kathleen Fuller acknowledges financial support from the Terry-Sanford Research Grant. Michael Goldstein acknowledges support from the Babson College Board of Research.

Do Dividends Matter more in Declining Markets?

Previous theoretical and empirical research indicates investors’ preferences for dividends vary across shareholder types. For example, depending on their tax bracket, some shareholders may prefer high dividend-paying stocks while others may prefer non-dividend-paying stocks. Anecdotal evidence also suggests that investors’ preferences for dividends may vary over time.  For example, in 2000, Fidelity began airing advertisements for a mutual fund consisting of only dividend-paying stocks in which an advisor informs his client this fund would help diversity his portfolio and moderate losses in down markets. Also in 2000, Standard & Poor’s predicted a revived interest in dividends, stating “market weakness may boost interest in dividends as investors begin to see the value of a ‘bird in the hand.’” These statements imply that investors’ preferences for dividend-paying stocks over non-dividend-paying stocks vary over time conditional on the state of the market, i.e., advancing and declining markets.

There are two reasons why investors might condition their preference for dividend-paying stocks on the state of the market: prospect theory and signaling theory. [1] Prospect theory, developed by Kahneman and Tversky (1979), indicates that people respond differently to certain verses probabilistic gains and losses and care more about losses than they do to gains. Prospect theory suggests therefore that investors may prefer the cash from dividend-paying stocks more when they predict future uncertainty or economic downturns, and less when the market is doing well.[2] Dividend-paying stocks provide a return where at least part of the return is a certain gain over those non-dividend-paying firms for which the entire gain or loss is uncertain. In markets that are moving upward, investors, while still valuing the relatively more certain gain, may value it less so since the preference for loss avoidance is mitigated. During periods of market decline, however, investors prefer dividends as a cushion to their returns, particularly if they are downside risk-averse. Such responses are similar to the “flight to quality” tendency that is seen during market declines documented by Connolly, Stivers, and Sun (2004). To the extent that investors value dividends as a certain return, investors may move from risky to less risky investments, in this case from non-dividend-paying to dividend-paying firms.

Another possibility relates to the signaling nature of dividends. Previous research suggests dividend-paying firms are better able to signal managers’ expectations than non-dividend-paying firms.[3] Again, this ability to signal may be more valuable in declining markets than in advancing markets. In declining markets, dividend-paying firms can signal positive information by just maintaining dividend payments; in such markets the prior commitment to pay dividends is more likely to be binding, increasing the value and importance of the signal. In advancing markets, it is expected that firms will generally perform well and the probability of, and costs associated with, financial distress are lower. The prior commitment to pay is therefore less likely to be binding in advancing markets and thus the value of dividend signals is likely to be lower. It is possible, therefore, that a policy of paying dividends during advancing markets conveys less information than a policy of paying dividends during declining markets. Overall, because non-dividend-paying firms do not credibly provide this signal, investors may discover that their state preferences for dividend payments cause them to value dividend-paying firms higher than non-dividend-paying firms during market downturns.

Both prospect theory and signaling theory suggest that the extent of investors’ preferences for dividend-paying stocks over non-dividend-paying stocks should be stronger in declining markets than in advancing markets. In this paper, we examine if investors have a preferences for dividend-paying firms in declining markets and determine whether prospect or signaling theory is the more likely explanation for this preference. Using S&P 500 returns as a proxy for market conditions, we examine the return behavior of dividend-paying and non-dividend-paying firms in both up and down markets from January 1970 to December 2000. We find that dividend-paying firms outperform non-dividend-paying firms by more in down markets than they do in up markets, implying that dividends do provide a differential benefit depending on market conditions. Our finding that the magnitude of the outperformance of dividend-paying stocks over non-dividend-paying stocks depends on market conditions is robust to a variety of adjustments for risk, including the CAPM, size and book-to-market quartiles, the Fama-French three-factor model, and Fama-McBeth style time-varying regressions, as well as various controls for size, time period, and alternative definitions of up and down markets.

Our results are also robust to a number of other controls. For example, these results are robust to exchange listing (NYSE vs. NASDAQ), indicating different market structures as well as the inherent differences across NYSE-listed and NASDAQ-listed stocks do not drive our results. To verify that these results are not primarily due to small stocks, we truncate the sample by examining only the middle 50% of the stocks based on market capitalization and still find that dividend-paying stocks outperform non-dividend-paying stocks by more in down markets than in up markets. To verify that down markets do not just proxy for expectations of increased future overall market risk, we segment our data based on estimates of implicit volatility from S&P stock options and find that dividend paying stocks continue to outperform non-dividend-paying stocks by more in down than up markets. We also find that these results hold across different sub-periods.

Finally, our finding that dividends matter more in declining markets is not driven by the cash payment itself. Kalay and Michaely (2000) note that time series variation may be related to actual dividend payments itself. They note that Black and Scholes (1974) and Litzenberger and Ramaswamy (1979, 1980, and 1982) have different results primarily due to differences in how they classify a dividend-paying stock: while Black and Scholes ascribe a stock as dividend paying even during months during which a dividend is not being paid, Litzenberger and Ramaswamy do not. Instead, for quarterly-dividend-paying stocks, Litzenberger and Ramaswamy classify the stock as a non-dividend paying for eight months that a dividend is not paid and as a dividend-paying stock for the other four ex-dividend months. To verify that our results are not driven by the cash payment, we examine the eight months of the year when dividend are not paid by dividend-paying stocks. We find dividend-paying stocks outperform non-dividend-paying stocks by more in down markets than in up markets even during the months when the dividend-paying firms did not pay a dividend, indicating that it is not the receipt of the cash itself that is driving these results.

While these broad results are consistent with both a prospect theory explanation and a signaling theory explanation, a number of tests indicate that the signaling theory explanation is more likely. First, we find that the different market reaction in up and down markets is due to the dividend-paying or non-dividend-paying nature of the stock and does not vary with dividend yield, implying the ability to pay a dividend – and not how much – is the cause of the differential performance across market conditions. Thus, the dividend yield itself is not driving the results; just the payment of a dividend results in dividend-paying firms outperforming non-dividend paying firms in down markets. The insignificance of the yield level is more consistent with a signaling theory explanation. Signaling theory focuses more on the ability to signal and not the previously established level while prospect theory would suggest that a larger amount of cash should matter more. Second, while our results hold for all stocks, the results are more pronounced for smaller stocks, even after all risk adjustments. While prospect theory would not suggest a preference across larger and smaller stocks, signaling theory would indicate that the signal is more valuable the lower the overall information environment for that stock. Fuller (2003) finds that firms with less information available to the market have greater price reactions to dividend changes and the signal provided. Since smaller stocks tend to have fewer analysts and less overall information, the extra signaling ability of small dividend-paying stocks over small non-dividend-paying stocks should be even more pronounced in declining markets. The signaling explanation is consistent with our finding of a more pronounced differential between dividend-paying and non-dividend-paying small stocks than large stocks.

Third, we find the results are also more pronounced for stocks with more trading volume, after controlling for risk. Amihud (2002), Butler, Grullon, and Weston (2004), and Lipson and Mortal (2004) have related liquidity to stock returns, the cost of raising capital, and capital structure. Chordia, Roll, and Subrahmanyam (2001) and Van Ness, Van Ness, and Warr (2004) also find that liquidity varies with the overall market movements; both find a pronounced change in down markets. We examine potential liquidity effects with respect to asymmetric performance for dividend paying stocks and find that dividend-paying stocks continue to outperform non-dividend-paying stocks more in down markets than in up markets even after controlling for volume. Again, prospect theory would not suggest any preference for high or low volume stocks, while signaling theory predicts that for firms with more dispersion in investors’ beliefs, the greater the value of the signal. For example, Frankel and Froot (1990) find that dispersion Granger-causes volume, and Harris and Raviv (1993) and Shalen (1993) find greater dispersion in investors’ opinions of the firm’s value leads to higher volume.[4] Thus, our results are consistent with the signaling theory prediction that the asymmetric response across dividend-paying and non-dividend-paying stocks should be positively correlated with volume. Collectively, these results provide more support for a signaling theory explanation than one involving prospect theory.

The remainder of the paper is organized as follows. Section I expands on how dividend payments relate to market movements and some unique characteristics of dividend payments, as well as providing testable empirical predictions. Section II presents the data and methodology. Section III describes the major empirical results, both overall as well as risk-adjusted using CAPM, Fama-French three-factor model tests, and Fama-McBeth style regressions. Section IV provides some robustness checks by examining alternate definitions for up and down markets, alternate model specifications, and controls for volatility and market listing. Section V examines other issues related to liquidity issues and dividend changes. Section VI examines whether signaling theory or prospect theory is the more likely explanation for the results found in this paper. Section VII concludes.

Market Movements, Dividends, and Empirical Predictions

a. Market movements

Although there are several reasons why investors might prefer dividend-paying stocks in down markets, traditional asset pricing models such as the Sharpe (1964) – Lintner (1965) CAPM or the Fama-French (1992, 1993) models do not account for state-specific investor preferences. Previous research suggests, however, that investors may have asymmetric preferences; for example, Harvey and Siddique (2000) find that risk-averse investors dislike negative skewness. In addition, an increasing body of work examines asymmetric responses of returns to market movements, and finds different return characteristics in up or down markets. Ang and Chen (2002) find that correlations between stocks’ returns and the market increase when the market declines. DeBondt and Thaler (1987) find different upside and downside betas for previous winners, although Ang, Chen, and Xing (2004) find that it is downside correlations, and not downside betas, that investors price. Additionally, Ang, Chen, and Xing (2004) find higher expected returns for firms whose correlations with the market increase when the market is declining. Using a Bayesian framework, Hong, Tu, and Zhou (2003) finds that there are significant differences across bull and bear markets, arguing that they should be examined separately. Other studies, such as Goldstein and Nelling (1999), find that the returns on REITs have different risk characteristics, with different correlation structures and betas, depending on whether the market has a positive or negative return.

Broadly rising or falling markets tend to indicate – albeit imperfectly – investors’ perceptions of the state of the economy in the future. In particular, broadly falling markets indicate either an increase in interest rates or a reduced expectation of future cash flows across most firms. During such times, both prospect theory and signaling theory indicate that investors may prefer cash payments to capital gains. For example, prospect theory directly implies that investors would prefer the certainty of a dividend payment relative to the more variable capital gain, especially when markets are moving down. While investors in non-dividend-paying firms could mimic this cash flow by selling stock, they would be doing so at depressed prices (given the market downturn) and incur potentially non-trivial transaction costs (a guaranteed loss). It is possible, therefore, that in these states of the world investors would prefer dividends, while in more positive states of the world the receipt of dividends would be less valuable. Further, as a great deal of stock is now held in tax-deferred accounts, it is no longer clear that dividends are tax-disadvantaged to selling stock.[5]

Similarly, signaling theory suggests investors have more demand for signals during declining markets. Bhattacharya (1979), John and Williams (1985), and Miller and Rock (1985) argue that dividends may signal managers’ private information regarding future earnings. When future projections of the economy are poor or uncertain, investors are likely to look to managers for information regarding their firm’s financial health and future prospects. Since the probability and costs of financial distress generally rise in down economies, this information is particularly valuable. Note that in this case it is the existence of a dividend payment that provides such a signal. In fact, it need not be that each individual dividend payment has great signaling value; instead, the maintenance of the commitment to pay regular dividends allows the firm to send a signal that the future prospects for the firm remain positive. A similar signaling argument can be made for the free cash flow hypothesis as developed by Jensen and Meckling (1976) and Jensen (1986), which suggests that managers can credibly signal they will not invest in negative NPV projects through the “bonding” of maintaining dividend payments. This signal of avoidance of future negative NPV projects should be most valuable when the market is down, since the probability that the bonding will be a binding constraint increases as the state of the economy decreases. Thus, whether the signal is the maintenance or increase in future earnings or the reduction of waste of free cash flows, the ability to signal should be most valuable in periods of poor overall stock market performance.

b. Dividends

We concentrate on dividend payments because dividends have a variety of special features that lend themselves nicely to studying investors’ preferences in declining markets. While Grullon and Michaely (2002) argue for examining the total payout of a firm, dividends have a variety of unique features not shared by repurchases. First, dividend payments are cash payments to all shareholders, while the benefit of share repurchases is a possible capital gain to those retaining their shares. Brennan and Thakor (1990) hypothesize that repurchases only benefit informed investors but dividend payments benefit all investors equally. Second, repurchases are not continuing obligations of the firm and may be suspended at any time, while the payment of a dividend generally signifies a continuing obligation to continue to pay a dividend (for that dollar amount or higher) in the future. Cook, Krigman, and Leach (2004) note that the timing of share repurchases is uncertain, including if and when they are completed, thus limiting their signaling ability. Howe, He and Kao (1992) also indicate that repurchases are discretionary and are not always observable by investors. However, the timing and completion of dividend payments is transparent: dividends are announced and then paid on a certain date. It is immediately clear to shareholders whether or not this obligation has been met in part or in full.

Finally, unlike repurchase programs, dividend payments are regularly scheduled. For example, for quarterly dividend payers, investors know in advance when to expect the next dividend payment. Yet, investors in non-dividend-paying firms do not know when they will next receive credible information about their investment. In particular, the value of dividend-paying stocks should be highest in those states of the world where the signal is of the most value, i.e., down markets when there is either increased uncertainty or when expectations of the future have become less rosy. As a result, investors may prefer dividend-paying stocks to non-dividend-paying stocks even in the months when the dividend-paying stock does not pay a dividend, as investors reasonably expect to get a signal within a few months for dividend-paying stocks.[6]

Focusing only on dividends is unlikely to bias our findings. Examining a similar time period, Boudoukh, Michaely, Richardson, and Roberts (2004) indicate that the correlation between dividend yield and payout yield is approximately 0.80 and was, for most of the time period, higher than repurchase yields measured similarly. To the extent that repurchases are beneficial in down markets, not considering repurchases will only bias us against finding significant results. (For example, if repurchases are beneficial, they would mitigate our results on non-dividend-paying stocks, since, by definition, non-dividend-paying stocks can only increase payout through share repurchases.) If repurchases are highly correlated with dividend payments, our results would still hold.

Other papers also support this focus on dividends. Although Fama and French (2001) claim that firms tend to view dividends as less necessary now than in the past, DeAngelo, DeAngelo, and Skinner (2004) find that this trend has occurred due to very small dividend payers omitting dividends; increases by large dividend payers have more than offset these omissions in value. Allen, Bernardo, and Welch (1998) find that firms have continued to pay more of their earnings in dividends than in repurchases, and Brennan and Thakor (1990) note that uninformed investors would prefer dividends to share repurchases due to adverse selection effects. There is also a large body of research that examines dividend and non-dividend-paying stocks separately, but that does not consider the state of the market. Papers such as Blume (1980), Litzenberger and Ramaswamy (1980, 1982), and Elton, Gruber, and Rentzler (1983) examine dividend yields in a modified version of Brennan (1970)’s after-tax CAPM that explicitly accounts for non-dividend-paying firms. These papers find that although there is a relation between expected returns and dividend yields for those firms that pay dividends, this relation does not hold for non-dividend-paying firms. Christie (1990) examines non-dividend-paying firms explicitly and finds that non-dividend-paying firms underperform firms of similar size. None of these papers, however, examine differing effects across different market conditions.[7]

c. Empirical implications

We examine dividend and non-dividend paying stocks separately to examine their differing responses to advancing and declining markets by testing a variety of hypotheses. We begin by examining the three empirical predictions which should hold under either the prospect theory explanation or the signaling explanation to investigate whether investors differentially prefer dividend-paying stocks in declining markets. First, we test whether dividend-paying stocks outperform non-dividend-paying stocks more in declining markets than in advancing markets. Under either prospect or signaling theory, this result should hold overall, after controlling for risk, for most sub-periods, and across most stocks (large vs. small, NYSE vs. NASDAQ, etc.). Alternatively, according to traditional asset pricing models, we should find no differences. Second, the maintenance of a dividend should cause a favorable response during a declining market but not during an advancing market, and the increase of a dividend should matter more in declining markets than advancing markets. Prospect theory would indicate that investors prefer cash in down markets more than in up markets, while signaling theory proposes that the maintenance of a dividend in a down market is a positive signal and the increase of a dividend in a declining market is a very strong signal. Alternatively, no difference should be seen under symmetric asset pricing models. Third, investors should prefer dividend-paying stocks to non-dividend-paying stocks even during those months between dividend payments during which no dividend is paid. Both prospect theory and the preference for signaling ability indicate that it is not the receipt of a cash payment, but the knowledge that such payments are coming, that matter. Alternative explanations (such as tax explanations) require cash payments and therefore the results would not hold in non-dividend-paying months for dividend-paying stocks if these explanations were correct.

Next, we determine if the signaling explanation is more likely than prospect theory to drive these results. First, while dividend-paying stocks outperform non-dividend-paying stocks in declining markets, this result should not vary with the amount paid. Prospect theory would imply that investors would prefer more cash to less in down markets, while signaling theory would suggest that just the existence of a dividend – and not its level – is preferred by investors. Therefore, our results should vary significantly with dividend yield if prospect theory is the driving explanation, and should not vary significantly with dividend yield if signaling theory is more correct. Second, although true for all stocks, small dividend-paying stocks should outperform small non-dividend-paying stocks in declining markets more than large dividend-paying stocks outperform large non-dividend-paying stocks in declining markets. Prospect theory does not differentiate across stock types; however, signaling theory implies the value of the ability to signal is more valuable for firms for which there is less information. As a result, smaller stocks should show more pronounced effects under the signaling theory explanation. Finally, the relative difference between up and down markets between dividend-paying and non-dividend-paying stocks may be highest for more liquid, high volume stocks. Although prospect theory does not indicate that there should be any difference across liquidity grouping for the preference of dividend-paying stocks over non-dividend-paying stocks, signaling theory suggests that since more liquid stocks may have more investor dispersion, and therefore, a significant difference between dividend-paying and non-dividend-paying stocks.

Data and Methodology

We identify a sample of dividend-paying and non-dividend-paying firms from the Center for Research in Security Prices (CRSP) monthly master file by examining all NYSE, AMEX, and NASDAQ listed stocks with data in CRSP over the 31-year period from January 1970 to December 2000. For each firm, we collect its monthly return, market capitalization and share volume data from CRSP. Since studies of returns and dividend yields such as Blume (1980), Litzenberger and Ramaswamy (1980, 1982), Elton, Gruber, and Rentzler (1983), and Christie (1990) note a U-shaped pattern in returns due to the unusual nature of non-dividend-paying stocks, we identify dividends by comparing the CRSP total return to the CRSP return that does not include dividends. If the returns are different, the firm is considered to have paid a dividend in that month, and the difference is considered to be the dividend. Although this method might result in the calculation of negative dividends, these likely errors were retained so as to not impart any bias by correcting errors on only one side.

Next, we used the distribution code in CRSP to determine if the dividend was a special, annual, semi-annual, quarterly, or monthly. As we are concerned with the signaling aspect of dividends, we only examine quarterly-dividend-paying stocks. Choosing quarterly-dividend-paying stocks increases the frequency of the possibility of signal observations while decreasing the length of time between potential signals. Thus, only quarterly-dividends were considered when determining whether a firm was a dividend-paying firm. All firms paying dividends other than quarterly dividends were considered non-dividend-paying firms. In this way, to the extent that non-quarterly dividends are at all considered positive, we will bias our results against finding any results for quarterly-dividend-paying firms.[8]

For each month we classify firms as either dividend paying or non-dividend-paying. If a firm paid a quarterly-dividend in that month, it is classified as a dividend-paying firm. Further, the months between quarterly-dividend payments are also classified as dividend-paying months. If a firm does not pay a dividend and then begins paying a dividend, it is classified as a non-dividend-paying firm until the month after the dividend is paid. That is, if a firm lists on January 1989 but does not pay a quarterly-dividend until June 1992, then the firm is considered a non-dividend-firm from January 1989 through June 1992 and is classified as a dividend-paying firm as of July 1992 until the firm stops paying a dividend, the firm is delisted, or the sample period ends. In this way, any positive return in the stock price due to the initiation of a dividend will be attributed to the non-dividend-paying stock group, thereby biasing our results against finding outperformance by dividend-paying stocks. If a firm pays a dividend and then stops paying a dividend, it is classified as a dividend-paying firm until the month after the scheduled quarterly-dividend payment. That is, a firm lists on January 1989 and begins paying a quarterly-dividend as of March 1989 but does not pay the June 1992 dividend, then the firm is considered a non-dividend-paying firm for January, February, and March 1989, a dividend-paying firm from April 1989 to June 1992 (the month of the expected quarterly-dividend), and a non-dividend-paying firm from July 1992 until it is either delisted, pays a dividend, or the sample period ends.[9] Thus, any negative surprise due to the cessation of a dividend will be attributed to the dividend-paying group, further biasing our results against finding outperformance by dividend-paying stocks.[10]

Because we want to examine if investors value firms that pay dividends, we must look at those periods where dividend payments should be most valuable. We use down markets as a proxy for those times when investors should more highly value dividend payment. Similar to Goldstein and Nelling (1999), we collect the S&P 500 returns for each month from CRSP and classify an up market as a month during which the monthly return on the S&P 500 was positive, while a down market is one where the S&P 500 posted a negative monthly return. Other papers examining asymmetric market responses have defined up/down markets differently: Ang and Chen (2002) define up and down markets by looking at returns in excess of the one-month Treasury bill, while Ang, Chen, and Xing (2004) define up and down markets by whether the excess market return is below its mean in the previous year. Given that the market historically has a positive excess return, these alternate definitions would result in more months being classified as down markets than will our more restrictive definition. As we are primarily interested in different responses in down markets, we use the more conservative definition.[11]

Overall, our sample includes 20,315 NYSE, Amex and NASDAQ listed firms for the 372 calendar months from January 1970 to December 2000. Each firm was classified as either dividend-paying or non-dividend-paying for every month of the sample period in which data was available, resulting in a total of 2,161,688 firm months in our time period, of which 1,392,422 are non-dividend-paying firm months and 769,266 are dividend-paying firm months. Table 1 describes the dividend- and non-dividend-paying firm months in our sample. Panel A provides averages across all observations for all 372 calendar months in our sample, while Panels B and C provide averages for those observations that occur in the 217 months in our sample where the S&P 500 had a positive return (“up markets”) and the 155 months where it did not (“down markets”). As Panel A indicates, the average market capitalization of firms during the months when they were classified as dividend paying is almost five times that of firms classified as non-dividend-paying. This larger size is due to having twice as many shares outstanding and an average price about 2.5 that of the non-dividend-paying firms. Trading volume was relatively similar for dividend-paying firms and non-dividend-paying firms. Betas for non-dividend-paying firms were slightly larger than those classified as dividend-paying firms. These general results in Panel A are similar for both up and down markets as indicated by Panels B and C, indicating that the relative relationships between dividend-paying and non-dividend-paying do not vary significantly with overall market movements.

Insert Table 1 here

Main Results: Overall and Risk-Adjusted

To investigate how investor preferences for dividends vary across market conditions, we examine returns of dividend-paying and non-dividend-paying stocks overall and in up and down markets separately. In addition to showing results for all markets, Table 2 presents evidence for the 217 months in our sample where the S&P 500 had a positive return (“up markets”) and the 155 months where it did not (“down markets”). Panel A indicates that we find that dividend-paying firms significantly outperformed non-dividend-paying firms by 0.37% per month across all the months in our sample, with this difference statistically significant at the 1% level for the Student t-test, the Wilcoxon sign-rank test, and the Kruskal-Wallis test. In addition, dividend-paying firms significantly outperformed non-dividend-paying firms in both up and down markets separately at the 1% level.

The magnitude of the difference, however, depended on the state of the market. Although dividend-paying firms returned only 0.16% more than non-dividend-paying firms during up markets, they provided 0.90% more than non-dividend-paying firms during down markets. We therefore test to see if dividend-paying stocks statistically outperform non-dividend-paying stocks more in declining markets than in advancing markets as signaling or prospect theory would indicate. Using a difference-of-differences test, we find that dividend-paying stocks outperformed non-dividend-paying stocks by 0.74% more in down markets than in up markets, and that this difference is significant at the 1% level, finding support for these theories.[12]

To verify that this overall result is not driven by one particular subperiod, Panel B examines three separate decade sub-periods: January 1970 to December 1979, January 1980 to December 1989, and January 1990 to December 2000. While the relative outperformance of dividend-paying over non-dividend-paying stocks does not hold for two of the three up markets, it does hold for all three of the down markets. More importantly, the differences-of-differences tests for all three sub-periods indicate that dividend-paying stocks outperform non-dividend-paying stocks by more in down markets than in up markets, and that this relative outperformance is significant at the 1% level. Thus, the difference-of-difference results are consistent both overall and in each of the three sub-periods. Collectively, the results in Table 2 support the first major empirical prediction that investors differentially prefer dividend-paying stocks over non-dividend-paying stocks more in declining markets than in rising markets.

Insert Table 2 here

A. CAPM Results

Although the state of the market affects the magnitude of the difference, so too does the level of risk of the stock. We examine the abnormal return for each firm i using the capital asset pricing model to determine expected returns; we estimate:

[pic] (1)

where Actual Returni is the return for firm i for that month, rF is the three-month Treasury bill for that month, rM is the return on the CRSP equally-weighted portfolio, and βi is the beta for stock i give by CRSP. We then compare the abnormal returns for dividend-paying and non-dividend-paying firms for all markets, up markets and down markets, as shown in Table 3. Although non-dividend-paying firms outperform dividend-paying firms in up markets by 0.19%, in down markets dividend-paying firms perform significantly better (i.e., significantly less negative returns) than non-dividend-paying firms by 0.60%, more than four times as much. As a result, the difference of differences of 0.79% is highly significant, indicating that the relative abnormal returns for dividend-paying stocks over non-dividend-paying stocks are larger in down markets than in up markets. The CAPM risk adjusted results in Table 3 are consistent with the univariate results found earlier in Table 2: in each case we find that dividend-paying stocks outperform non-dividend paying stocks by more in down markets than in up markets. Thus, the answer to our central question – do investors prefer dividend-paying firms to non-dividend-paying firms in down markets – is yes, even after controlling for risk using beta and the CAPM.

Insert Table 3 here

B. Size and Market-to-Book Results

Fama and French (1992) and others have suggested that book-to-market and size are also important determinants of returns. Christie (1990) also suggests that size is an important factor when examining the returns of dividend-paying and non-dividend-paying stocks. To test if the results are robust to segmentation by book-to-market and size, we replicate the original Fama and French (1992) methodology by dividing our samples of dividend-paying and non-dividend-paying stocks into four market capitalization quartiles and then further sub-dividing those quartiles into four book-to-market quartiles, for a total of 16 sub-groups for each of the dividend-paying and non-dividend-paying stocks.[13] The end result is thirty-two portfolios: sixteen portfolios of dividend-paying stocks based on book-to-market and size quartiles, and sixteen portfolios for non-dividend-paying stocks. We then calculate the average excess return (return of a firm in month t over the three-month Treasury bill rate in month t) for each portfolio.

Insert Table 4 here

Table 4 examines the excess return characteristics for the portfolios formed on size and book-to-market. Overall, size seems not to matter as much as book-to-market in determining the difference between the dividend-paying and non-dividend-paying groups for all markets. As shown in Panel A, non-dividend-paying stocks seem to outperform dividend-paying stocks for the lower book-to-market groups across all markets, with the reverse true for the higher book-to-market quartiles. However, as Panel B shows, in up markets the non-dividend-paying stocks outperform the dividend-paying stocks for low book-to-market quartiles, but for the higher book-to-market groups, size becomes a factor and only the smaller stocks in the higher book-to-market quartiles have a significant difference. Panel C, however, presents results that during down markets, dividend-paying stocks do better than non-dividend-paying stocks for all book-to-market categories, but only for the smaller stocks. Thus, the results are strongest for low book-to-market small stocks.[14]

Panel D examines the differences of differences and finds reasonably strong support for dividend-paying stocks outperforming non-dividend-paying stocks by more in down markets than in up markets, as predicted by both the signaling and prospect theory hypotheses. However, the results are the weakest for the largest stocks, particularly those with medium to high book-to-market values, and strongest for small stocks and lower book-to-market values. These results therefore provide slightly more support for the signaling hypothesis over prospect theory. Smaller, low book-to-market (i.e., high market-to-book) stocks are likely to have less information provided than larger, high book-to-market firms. As a result, the value of the receipt of a signal may be stronger for these firms, particularly when the general economy (as proxied by the stock market) looks less favorable. Therefore, these results are consistent with a signaling explanation. Prospect theory, on the other hand, would not differentiate across these firms; we would expect to see no systematic difference across these categories. Thus, the results in Table 4 support the overall suggestion that investors prefer dividend-paying stocks to non-dividend-paying stocks in down markets more than in up markets, and also provide some support for the signaling explanation as to why they have this preference.

C. Fama-French Three-Factor Model Results

Similar to Ang, Chen, and Xing (2004), we also use the Fama and French (1993) (FF) three-factor model to estimate abnormal returns for monthly portfolios. This model controls for non-independence of returns over time, size, and book-to-market effects. We estimate a modified FF three-factor model as follows:

[pic] (2)

where rit is the monthly return on a portfolio i of dividend-paying or non-dividend-paying firms, rFt is the monthly return on three-month Treasury bills, RMRF is the excess return on a value-weighted aggregate market proxy, SMB is the difference in the returns of a value weighted portfolio of small stocks and large stocks, HML is the difference in the returns of a value-weighted portfolio of high book-to-market stocks and low book-to-market stocks as in Fama and French (1993), and DOWN is a dummy variable which takes on the value one if the market is down and zero if the market is up. For each month we calculate the excess return on an equally-weighted portfolio composed of either all dividend-paying firms or all non-dividend-paying firms. We then regress this portfolio return on the factors in equation (2) and examine the differences in coefficients. We would expect that if investors prefer dividend-paying firms in down markets, that for the dividend-paying portfolio the coefficient on DOWN should be significantly higher than that of the non-dividend-paying portfolio.

1. Econometric issues and weighting methodology

To perform these analyses and those that follow, we use equally-weighted portfolios. There are a number of factors in favor of equally weighting of portfolios. First, we are examining the responses of dividend and non-dividend portfolios to up and down markets, where up is defined as a positive S&P 500 return. The S&P 500 index is itself a value-weighted portfolio. Thus, the value-weighted dividend and non-dividend portfolios will be very highly correlated with the variable that conditions on the up and down market, namely S&P 500 index.[15] Many of the same stocks will determine the return characteristics of both the portfolios and the index that divides our sample. This effect will be particularly exacerbated for the value-weighted dividend portfolio, given the structure of the S&P 500 index, which will further complicate comparisons across the dividend and non-dividend portfolios.[16]

A second issue related to the use of equally-weighted portfolios is related to whether an investor can trade on this information. While an equally-weighted portfolio may incur more transaction costs due to the increased trading from more frequent portfolio rebalancing, the issue in this paper is the differential asymmetric response of dividend and non-dividend-paying stocks in up and down markets. Given that the state of the market is fixed during any one month, investors cannot trade on this information; it is a state of the world for all stocks. Furthermore, even if it were possible to trade on the state of the market, it would be prohibitively expensive for investors to move from an all dividend-paying portfolio to an all non-dividend-paying portfolio based on the state of the market. Therefore, given the focus of the question and the nature of the test, trading considerations are not a primary concern.

Third, the results in Table 4 for the sixteen size and book-to-market portfolios indicate that the results vary with size, so making size-weighted portfolios would somewhat obfuscate the results. Ang and Chen (2002) also note that these asymmetric results decrease with size; therefore, value-weighted portfolios would tend to understate the magnitude of the results. In addition, Fama and French (1993, 1996) find that three-factor models have systematic problems explaining returns for small stocks, making this methodology not as useful.

Finally, as Fama (1998) notes, the weighting structure of the portfolio should determined by the underlying question. Because the question under investigation in this study is more a question about the particular nature of an individual stock – does it or does it not pay a dividend – and not particularly about a portfolio, Fama (1998) implies that equally weighting is appropriate. Equally-weighted portfolios allow for an examination of individual characteristics of a stock by treating each stock similarly, while value weighted portfolios can be primarily driven by a limited number of stocks. Results from equally-weighted portfolios therefore better represent the “average” stock. A number of recent papers, such as Lowry (2003), have therefore presented equally-weighted results. In addition, dividend policy is a management choice variable. As managers do not control a portfolio of firms, but instead a single firm, managers are more concerned with the results for an average stock. As a result, we use equally-weighted portfolios in these analyses.

2. Fama-French overall results

We first verify that the FF three-factor model using our sample provides consistent results with prior research. As indicated in Panel A of Table 5, the coefficients on the FF three-factors indicate that the data load properly on the factors, do not have significant alphas, and have very high adjusted R2 of around 90% for both the non-dividend-paying and dividend-paying portfolios, indicating that the basic FF model works well with this data. In addition, although the factor loadings are significantly different from each other, contrary to the hypotheses in Brennan (1970) or the empirical results in Black and Scholes (1974), Litzenberger and Ramaswamy (1979, 1980, 1982), and Blume (1980), we do not find differences between dividend-paying and non-dividend-paying stocks overall in terms of alpha outperformance.

Insert Table 5 here

3. Modified Fama-French results

Panel B of Table 5 presents the results for the modified FF model with the additional dummy variable DOWN. In general, we find that the return-generating process is different for dividend-paying stocks than for stocks that do not pay a dividend. In particular, we find that the state of the market affects the return of the portfolios when the market is going down. More specifically, we find that the coefficient on the DOWN market dummy variable (-1.34%) is negative and significant for non-dividend-paying firms, indicating that non-dividend-paying firms have a different return-generating function in down markets. However, while the coefficient on the DOWN market dummy variable (-0.29%) is also negative for the dividend-paying firms, it is not significantly different from zero.

More importantly, the coefficient on the DOWN dummy variable is significantly more negative for non-dividend-paying firms than it is for dividend-paying firms. This result indicates that the main result that investors prefer dividend-paying firms over non-dividend-paying firms more in down markets than in up markets holds even after controlling for risk using the Fama-French factors.

D. Fama-McBeth Style Regressions

We also examine Fama-McBeth style regressions to determine if dividend-paying stocks outperform non-dividend-paying stocks in down markets. The regressions were run cross-sectionally each month for every firm as in Fama and McBeth (1973). We estimate the following:

[pic] (3)

where rit – rFt is the return on a stock in month t minus the three-month Treasury bill return for month t, [pic] is the firm’s beta measured for the prior year for month t, Ln(Mktcap) is the natural log of the firm’s market capitalization for month t, Ln(BVEquity) is the natural log of the firm’s book value of equity for month t, and DIV is an indicator variable that equals one if the firm pays a dividend in month t and zero if the firms does not pay a dividend in month t. Table 6 reports that the coefficient for DIV is significantly greater in down months (0.3759) than in up months (0.3608) at the 1% level, indicating that in down months dividend-paying firms outperform non-dividend-paying firms. This shows that investors value dividend-paying firms more in down markets and more so than in up markets.

Insert Table 6 here

E. Dividend Changes

The results thus far support the first main empirical prediction suggested by both signaling and prospect theory, i.e., that investors do have a preference for dividend-paying stocks in down markets. The second main empirical prediction implied by both signaling and prospect theory relates to whether changes in dividend payments matter based on market conditions. From an asset pricing or dividend capture/tax clientele perspective, we would expect that market responses to changes in dividends would not be a function of the state of the market. In other words, the market should respond similarly to increases in dividends in either an up or down market. Not changing a dividend would likely have little effect from an asset pricing perspective regardless of the overall state of the market.

From either a signaling or prospect theory perspective, however, we would expect an asymmetric response. Prospect theory indicates that investors prefer cash in down markets more than in up markets. The same is true under the signaling theory explanation. In down markets, investors’ perceptions of future profits tend to be lower, while investors tend to have positive outlooks on future earnings during up markets. Increasing dividends in down markets therefore provides a much stronger signal about the future than a similar increase during an up market. Similarly, not changing a dividend during up markets likely provides little additional information to investors. However, during a down market, when investors may be more pessimistic about the overall economic outlook, not changing a dividend provides investors with a reassuring signal that the company is not headed for bankruptcy. Finally, decreasing dividends in down markets may be expected by investors and thus convey less information than when firms decrease dividends in up markets when everything is supposedly going well.

Thus, we would expect that in down markets dividend increases should have higher price reactions than in up markets, and dividend decreases would have lower (less negative) price reactions in down markets than up markets. Further, if the maintenance of dividends provides information, then we would also expect in down markets that for firms that had no changes, the abnormal return would be higher than for firms with no dividend change in up markets.

We test this second empirical prediction that investors respond differently to the maintenance or changes in the dividend based on market conditions by examining the market's reaction to dividend changes and no changes during up and down markets. Specifically, to determine if investors’ value changes in dividends differentially, we examine changes in quarterly-dividends gathered from CRSP from 1970 to 2000. The only restrictions we place on the sample it that there must be five days of returns surrounding the announcement listed on CRSP, the dividend is paid on ordinary common shares of U.S.-incorporated companies, and the change is not be a dividend initiation or omission.[17] Our sample included 3,294 firms with 18,537 increases, 4,595 decreases, and 93,537 no changes. We follow Brown and Warner’s (1985) standard event study methodology to calculate CARs for the five-day period (-2, 2) around the announcement date supplied by CRSP.

We estimate the abnormal returns using a modified market model:

[pic] (3)

where ri is the return on firm i and rm is the equally-weighted market index return. We do not estimate market parameters based on a time period before each change because some firms have frequent dividend changes and thus, there is a high probability that previous changes would be included in the estimation period thus making beta estimations less meaningful. Additionally, Brown and Warner (1980) show for short-window event studies that weighting the market return by the firm's beta does not significantly improve estimation.

As shown in Table 7, price reactions to dividend increases are less in up markets (0.857%) than in down markets (1.206%), and this 0.349% difference is significant at the 5% level for the Student t-test and at the 1% level for the two non-parametric tests. In addition, dividend decreases have less negative returns if announced during down markets (-0.324%) than up markets (-0.375%); although not different at normal significance levels parametrically, this 0.051% difference is statistically different for the two non-parametric tests at the 1% level. Further, firms that maintained their current dividend payments in down markets experienced positive abnormal returns (0.170%) while firms that maintained their current dividend levels in up markets had abnormal returns (0.046%) that are insignificantly different that zero. The 0.124% difference in abnormal returns between firms that maintained their dividend in up and down markets is significant at the 1% level for the parametric and non-parametric tests, indicating a much stronger and positive response for firms that just maintain their dividend in down markets over the non-response for maintaining a dividend in down markets. Thus, the differences-in-means between up and down markets were statistically significant for three groupings (increases, decreases, and no changes).

Collectively, the results in Table 7 support the second main empirical prediction that investors respond differently to changes – or even the maintenance – of a dividend in advancing and declining markets. These results also reconfirm the earlier results that there are asymmetric responses in up and down markets and thus provide further support to either the signaling or prospect theory explanations.

Insert Table 7 here

F. Dividend-paying stocks during non-dividend-paying months

Kalay and Michaely (2000) note that time series variation may be related to actual dividend payments itself. Therefore, one possibility is that dividend-paying firms outperform non-dividend-paying firms simply because of the return in the month the firm paid the dividend, and in the remaining months when no dividend is paid returns for dividend and non-dividend-paying firms are similar. In other words, it could be that our findings that dividends matter more in declining markets may be driven by the cash payment itself. If this is true, then there may be no information or signal in the fact that a firm continues to pay a dividend but only a signal in the dividend payment itself when it is received.[18] Alternatively, it could be that the knowledge that a signal will be received (via the dividend payment) is in itself valued as well. Similarly, under prospect theory, the knowledge that cash is to be received should still be valued more in down markets than in up markets, and not just the receipt of cash itself.

Thus, the third main empirical prediction indicates that investors should still prefer dividend-paying stocks over non-dividend-paying stocks not just during those months in which the dividend is paid, but also in those months between dividend payments. In some sense, the key question here is what is the definition of a dividend-paying stock? Is it that that the stock paid dividends this month, or that this firm has paid dividends in the past and is expected to continue paying on a regular basis? Different authors have defined this differently. For example, Kalay and Michaely (2000) note that Black and Scholes (1974) and Litzenberger and Ramaswamy (1979, 1980, and 1982) have different results primarily due to differences in how they classify a dividend-paying stock: while Black and Scholes ascribe a stock as dividend-paying even during months during which a dividend is not being paid, Litzenberger and Ramaswamy do not. Instead, for quarterly-dividend-paying stocks, Litzenberger and Ramaswamy classify the stock as a non-dividend paying for eight months that a dividend is not paid and as a dividend-paying stock for the other four ex-dividend months.

Throughout this paper, we have defined dividend-paying stocks on a month-by-month basis in a manner similar to that in Black and Scholes (1974), i.e., a quarterly-dividend paying stock is considered a dividend-paying stock for all twelve months of the year, and not just the four months of the year during which a dividend is being paid, as in Litzenberger and Ramaswamy (1979, 1980, and 1982). To verify that our results are not driven by the cash payment, we examine the eight months of the year when dividend are not paid by dividend-paying stocks. Specifically, we eliminate the returns for dividend paying firms in the month the dividend is paid and compare the returns of non-dividend-paying firms to the returns of dividend-paying firms in months with no dividend payments. In this way, we are explicitly examining those firm-months that Black and Scholes would define as dividend-paying that Litzenberger and Ramaswamy would define as non-dividend-paying, and removing those firm-months for dividend-paying stocks for which they agree (i.e., the months in which the dividend is paid).

As indicated in Panel A of Table 8, we find that for up markets, dividend-paying and non-dividend-paying firms have the same average monthly return (3.72%), but in down markets, dividend-paying firms (-3.03%) still significantly outperform non-dividend-paying firms (-2.36%), even when the dividend return is excluded from the dividend paying firms’ returns. The 0.67% difference of differences is significant at the 1% level. Further, we also estimate the modified FF model and find in Panel B that again, the down market dummy variable is insignificantly different from zero for dividend-paying firms (-0.2%8) during months when they are not paying a dividend, and, more importantly, is significantly higher than that for non-dividend-paying firms (-1.34%) at the 1% level.

Insert Table 8 here

Thus, the results in both panels of Table 8 support for the third main empirical prediction that dividend-paying stocks outperform non-dividend-paying stocks by more in down markets than in up markets even during the months when the dividend-paying firms did not pay a dividend, indicating that it is not the receipt of the cash itself that is driving these results.

G. Summary of Results and Empirical Predictions

Overall, the results in Tables 2 through 8 indicate that dividend-paying stocks outperform non-dividend-paying stocks by more in declining markets than they do in advancing markets. The results in tables 2 through 6 individually and collectively support the first main empirical prediction, namely that investors differentially prefer dividend-paying stocks in declining markets as predicted by either the signaling theory explanation or the prospect theory explanation. In addition, the results in Table 7 support the second main empirical prediction that changes or maintenance of a dividend matter more in down markets than up markets. The results in Table 8 show that these findings are not merely due to the cash payment itself, supporting the third main empirical prediction. Collectively, these results indicate that either the signaling explanation or the preference theory explanation can provide additional understanding to investors’ behavior over and above those found in traditional symmetric asset pricing models that do not allow for such asymmetric responses.

III. Robustness Checks: Small stocks, Bull/Bear markets, Volatility, and Exchange Listing

Overall, the results provide convincing evidence that dividend-paying stocks outperform non-dividend-paying stocks, particularly in down markets. To verify further that these results hold under a variety of specifications, we examine potential small stock bias, alternative definitions of up and down markets, perform a further examination of risk-adjusted sub-period results, and search for possible liquidity effects.

A. Small Stocks

The results in Table 5 were determined by using the three-factor Fama-French model to adjust for risk for all of the stocks in our sample. One possible issue is the small stock bias due to poor performance of the Fama-French model with respect to small stocks. It is unlikely, however, that this small stock bias is determining the results. First, Panel A of Table 5 demonstrates that the model performs as expected using our sub-samples of dividend-paying and non-dividend-paying stocks. Second, the results in Table 5 are consistent with the results in Tables 2, 3, 4, and 6.

Even so, one can mitigate the small stock issue when using the Fama-French model by removing some of the smaller stocks from the analysis and verifying the results. To investigate whether the small stock bias is an issue, we removed the lower 25% of firms based on market capitalization. That is, each month we removed the smallest 25% of our firms. We then estimated the modified Fama-French model removing the bottom quartile of stocks based on market capitalization. Panel A of Table 9 indicates that the overall result noted in Table 5 that dividend-paying firms outperform non-dividend-paying firms by more in down markets than in up markets continues to hold for this subset of firms. For this subsample, the coefficient on DOWN for the non-dividend-paying firms is -0.81%, while for dividend-paying firms the coefficient is -0.29%; this difference in coefficients is significant at the 5% level.

Further for evenness, we also re-ran the results removing the top quartile as well, so as not to impart any bias due to the truncation methodology. We therefore truncated the distribution of firms at both the upper and lower 25%, so that the tests were run on the middle 50% of the firms. As indicated in Panel B, the coefficient on DOWN is -1.10% for non-dividend-paying stocks, while the coefficient on DOWN for dividend-paying stocks is much higher at -0.22%; this difference in coefficients is significant at the 1% level.

For both panels, the adjusted R2 are higher than 90%, indicating that the model works well. Thus, the results in both panels indicate that dividend-paying firms outperform non-dividend-paying firms in down markets, indicating that it is not a small firm bias that is driving our results. Given these results, we continue to use the Fama-French methodology for adjusting for risk in other robustness checks and further tests.

Insert Table 9 here

B. Bull and Bear Markets

To examine if the definition of up and down markets affects the results, we run two tests. The first, not shown here, redefines an up month as a month with a positive excess return, i.e., a month where the S&P 500 return exceeded the risk-free rate for that month, and a down month as a month with a negative excess return, similar to the definitions used in Ang and Chen (2002). While this is a less stringent definition of a down month, it seems reasonable that investors would require a positive market premium. All of the results in the paper continue to hold under this alternate definition.

Another way to define advancing and declining markets is to use the concept of bull and bear markets. The definitions of bull and bear markets are a bit circumspect, in that the beginning and ends of these periods are only known ex post. The bull and bear markets used in this analysis are as defined by Ned Davis Research. Overall, there were eight separate bull markets and eight bear markets in our sample, resulting in 259 months being classified as a bull month, and 113 months classified as a bear month. Panel A of Table 10 replicates the univariate tests in Panel A of Table 2 and while Panel B of Table 8 replicates the modified Fama-French test found in Panel B of Table 5, using the Ned Davis Research definitions of a bull or bear market to define months in place of the previous definitions used for up and down markets. In each case, the results for bull and bear markets support the results reported previously that dividend-paying stocks outperform non-dividend-paying stocks by more in down markets than in up markets. Collectively, the results of these two tests indicate that it is not the definition of up and down markets that is driving these results.

Insert Table 10 here

C. Expected Future Volatility

An alternative explanation of our results is that it is not the down market to which investors are reacting but instead increased uncertainty in the market. Thus, we test whether the overall volatility perceived in the market could be driving our results. We estimate market sentiment using the Chicago Board Options Exchange Volatility Index (VIX). For our sample period, this data is available only starting in 1986. This index represents the implied volatility of an at-the-money option on the S& 100 Index with 22 trading days to expiration. For each month we calculate the change in the VIX measure. This change is then compared to the average change for the previous year. If the monthly change is greater than the past year’s average change, then that month the market is considered to be estimating that future volatility will be high and if the monthly change is less than or equal to the past year’s average change, the market is considered to estimate that the future will have low volatility. We then estimated our modified Fama-French model adding an indicator variable that for each month equals one if the market is expecting high future volatility and zero if the market is expecting low future volatility. That is, we estimate:

[pic]

where rit – rFt is the return on a equally-weighted portfolio of either dividend or non-dividend-paying stocks in month t minus the three-month Treasury bill return in month t, RMRF is the excess return on a value-weighted aggregate market proxy for month t, SMB is the difference in the returns of a value-weighted portfolio of small stocks and large stocks for month t, HML is the difference in the returns of a value-weighed portfolio of high book-to-market stocks and low book-to-market stocks for month t, DOWN is an indicator variable that equals one if the market is down and zero if the market is up, and VOL is an indicator variable that equals one if the market expects high volatility and zero if the market has low volatility.

Panel A of Table 11 finds that for the entire period from 1986 to 2000, the volatility is not a significant factor in determining returns for both dividend-paying and non-dividend-paying stocks. The coefficient on the VOL variable is -0.0024 for non-dividend-paying stocks and -0.0045 for dividend-paying stocks. Neither coefficient is significantly different from zero at traditional significance levels nor are the coefficients statistically different from each other. However, the coefficient on the DOWN variable for non-dividend-paying stocks (-2.22%) is significantly different from zero and, more importantly, is still significantly lower than the coefficient for dividend-paying stocks (-0.27%), and this difference is significant at the 1% level. Thus, even after controlling for the market’s sentiment of risk, investors still prefer dividend-paying stocks over non-dividend-paying stocks in down markets.

In addition to estimating this regression using data form 1986 through 2000, we also re-ran this model excluding data from 1986 and 1987. Connolly, Stivers and Sun (2004) find that in October 1987 the VIX peaked at around 150%.  In the subsample from 1988 through 2000, the VIX peak is about 50%. To verify that this particular time period is not skewing the results, we re-estimated the regression excluding data from 1986 and 1987. The results in Panel B excludes 1986 and 1987 data; all results are similar to the results in Panel A, indicating that these results are not due to issues related to the October 1987 market crash and rebound.

Insert Table 11 here

D. Exchange listing

As a further robustness check, we separated firms based on their primary market listing (NASDAQ or NYSE-Amex) and examined the modified FF model for dividend-paying and non-dividend-paying firms on each market separately. Results in Panel A (NYSE/AMEX stocks) and Panel B (NASDAQ stocks) of Table 12 indicate that exchange listings do not impact our results. Panel A indicates that the coefficient on the DOWN variable for dividend-paying firms (-0.28%) is insignificantly different from zero and is larger than that for non-dividend-paying firms (-0.54%) in down markets for NYSE-Amex stocks, which is significant at the 1% level. Overall, the 0.26% outperformance of dividend-paying firms over non-dividend-paying firms in down markets is significant at the 5% level. Similarly, Panel B shows that for NASDAQ stocks, the coefficient on the DOWN variable for dividend-paying stocks is also insignificantly different from zero (-0.47%) and is much larger than the coefficient for non-dividend-paying stocks (-1.92%); this difference is significant at the 1% level. These results indicate that for both NYSE-Amex and NASDAQ firms, dividend-paying stocks outperform non-dividend-paying stocks in down markets.

Thus, neither NASDAQ nor NYSE-Amex firms are primarily driving the results. As a final check, in Panel C we compared the DOWN variable for just for the dividend-paying firms to verify that there was not a significant difference in down markets for the dividend-paying firms across these two markets. We see there is no significant difference in the DOWN coefficients for dividend-paying stocks across exchanges.

Insert Table 12 here

IV. Signaling vs. Prospect Theory

Collectively, the previous results have shown that dividend-paying stocks outperform non-dividend-paying stocks in down markets. These results are inconsistent with traditional asset pricing models. However, these results are consistent with either prospect theory or a signaling explanation. In this section, we attempt to differentiate between these two theories of investor behavior to see if either is more likely to explain these results.

A. Dividend Yield, Tax Clienteles, and Signaling

The previous tests focus only on whether or not firms pay dividends, and not the magnitude of dividend payments. In this way, we control for the U-shaped pattern in dividend yields that resulted from non-dividend-paying stocks as noted in Christie (1990), among others. A question arises, however, whether these results are sensitive to the size of the dividend yield. Prospect theory implies that investors prefer more cash to less in down markets. If the previous results are due to prospect theory, the results should be stronger for high-dividend-yield stocks than for low-dividend-yield stocks. In addition, there should not be much of a difference between the low-dividend-yield and the non-dividend-paying stocks.[19] Signaling theory would suggest that just the existence of a dividend – and not its level – is preferred by investors.[20] Thus, if the additional value of the dividend were due to the signaling nature of dividends, it may matter more that the firm pays a dividend at all and not the magnitude of the dividend, and there should be a much larger difference between the low-yield and non-dividend-paying firms.[21] Therefore, our results should vary significantly with dividend yield if prospect theory is the driving explanation, and should not vary significantly with dividend yield if signaling theory is more correct.

The results in Panel A of Table 13 for the quintile portfolios based on dividend yield of dividend-paying stocks indicate that each quintile loads differently on the Fama-French factors. In particular, the smallest two dividend yield quintiles have statistically significant positive alphas, while the highest dividend yield has a statistically significant negative alpha. Not surprisingly, the F-test rejects the null of equality of the alphas across the quintiles at the 1% level. Even so, we cannot reject the hypothesis that the coefficients on the DOWN variable are statistically different across the quintiles. This result indicates that the results presented in Panel B of Table 5 and in previous tables on the asymmetric response of non-dividend and dividend-paying stocks to down markets are not related to dividend yield, but rather to the existence of dividend payments themselves. In fact, all of the coefficients on the DOWN variable are insignificantly different from zero for all quintiles (except for the lowest dividend yield quintile).

Insert Table 13 here

As a further test, Panel B examines the difference between the non-dividend-paying group and the quintile with the lowest dividend yield. In this case, the coefficients on the alphas and the HML book-to-market variables were not significantly different from each other. However, the coefficients on the DOWN variable were significantly different for the non-dividend-paying (-1.34%) and lowest dividend yield portfolios (-0.67%), further indicating that it is the dividend payment, and not the magnitude of the payment, that drives previous results.

The results in Panels A and B indicate a much larger difference between the non-dividend-paying and low dividend yield portfolios than among the dividend-paying portfolios themselves. These results support the signaling hypothesis over prospect theory or a tax clientele/dividend capture hypotheses for explaining the reason for the asymmetric responses in up and down markets shown by the data. These results do not support Brennan (1970) or Litzenberger and Ramaswamy (1979, 1980, 1982), in that the lower dividend yield stocks seem to outperform the high dividend yield stocks on a pre-tax nominal return basis. Instead, these results are consistent with the findings in Miller and Scholes (1982).

Collectively, the results indicate that it is the payment or non-payment of dividends – not the level of the payment – that drives the results that dividend-paying firms outperform non-dividend-paying firms in down markets. To this extent, they support earlier findings by Blume (1980), Litzenberger and Ramaswamy (1980, 1982), Elton, Gruber, and Rentzler (1983), and Christie (1990) that non-dividend-paying stocks are different from dividend-paying stocks. Further, it seems unlikely that the prospect theory hypothesis is driving the results, but that dividend signaling (either the dividend-signaling hypothesis or the free-cash-flow hypothesis) is more likely the cause. Overall, these results support the signaling explanation that it is the ability to signal with the next regularly scheduled dividend that is driving the overall results.

B. Size Results

Christie (1990) indicates that return differentials of dividend-paying and non-dividend-paying stocks may be a function of size. Prospect theory and the signaling explanation for the previous results have different implications based on the market capitalization of the stock. While a prospect theory explanation does not differentiate based on the size of the company (cash is always good), the value of the ability to signal is more valuable for firms for which there is less information. DeAngelo, DeAngelo, and Skinner (2004) argue that the degree of information asymmetry is likely to be negative related to firm size. As a result, smaller stocks should show more pronounced effects under the signaling theory explanation as smaller stocks tend to have less information available for investors, making the signal of dividends more valuable for these stocks. Therefore, we would expect small dividend-paying stocks should outperform small non-dividend-paying stocks in declining markets more than large dividend-paying stocks outperform large non-dividend-paying stocks in declining markets if signaling theory is a more likely explanation.

To examine this difference, we estimated the modified Fama-French model for firms quartiled by their size. As indicated in Panel A of Table 14, the smallest quartile and the second quartile have highly significant difference (1% level) in the coefficients on the DOWN variable between dividend-paying firms (-0.20%) and non-dividend paying firms (-2.32%). The next quartile has a significant difference at the 5% level for the DOWN coefficient, while the largest quartile has no significant difference between the coefficients on the DOWN variable for dividend-paying versus non-dividend paying firms. In addition, none of the coefficients for the DOWN variable for dividend-paying stocks were significantly different from zero. However, the coefficients for the DOWN variable for non-dividend paying stocks for all but the largest quartile were significantly different from zero at the 1% level. Further investigation shows that the difference between the coefficients for the DOWN variable between dividend-paying firms and non-dividend-paying firms is monotonically decreasing as the size quartile increases (from 0.38% for the largest quartile to -2.52% for the smallest quartile). This result indicates that indeed the smallest firms have a greater impact of paying a dividend, again supporting a signaling explanation more than a prospect theory explanation.

Insert Table 14 here

C. Liquidity Results

Liquidity is a desirable feature for most stocks. A number of papers, such as Amihud and Mendelson (1986), indicate that returns may be positively related to liquidity. In particular, the ability to switch in and out of stocks based on market conditions may be a function of overall liquidity: for less liquid stocks, we would expect to see less of a difference in up and down markets than for highly liquid stocks, as it is easier to move in and out of more liquid stocks. In addition, to the extent that non-dividend-paying stocks are less desirable in down markets, we might expect a bigger difference between up and down markets in highly liquid non-dividend paying stocks than in most dividend-paying stocks. For NYSE and NASDAQ stocks, respectively, Chordia, Roll, and Subrahmanyam (2001) and Van Ness, Van Ness, and Warr (2004) find that overall market liquidity varies with market movements. In particular, Chordia, Roll, and Subrahmanyam (2001) note that liquidity changes by much more in down markets than it does in up markets.

Liquidity may also proxy for a divergence of opinion among investors; if everyone agrees on the price, there would be little trading.[22] Frankel and Froot (1990) find that dispersion Granger-causes volume, and Harris and Raviv (1993) suggest that trading volume is higher for firms with more information.[23] While prospect theory does not indicate that there should be any difference across liquidity grouping for the preference of dividend-paying stocks over non-dividend-paying stocks, signaling theory suggests that since more liquid stocks may have more investor dispersion, the relative difference between up and down markets between dividend-paying and non-dividend-paying stocks may be highest for more liquid, high volume stocks. Therefore, while prospect theory would suggest no difference across volume categories, the signaling explanation suggests that relative difference between dividend-paying and non-dividend-paying stocks should be strongest for the most liquid stocks, as the ability to receive a signal is the most valuable if there is relatively less certainty across investors.

We therefore divided the sample into quintiles based on yearly trading volume in shares and then examined the results in each volume quintile for dividend-paying and non-dividend-paying stocks. The results, as shown in Table 15 indicate that the basic results hold: in each of the volume quintiles, dividend-paying stocks significantly outperform non-dividend-paying stocks in down markets at the 5% level or better, supporting our main findings. In addition, a number of the other issues also hold. The coefficients on the DOWN variable decrease monotonically with volume for both non-dividend-paying and dividend-paying stocks. For the lowest quintile, the coefficients on the DOWN variable are -0.65% for non-dividend-paying stocks and 0.06% for dividend-paying stocks; neither is significantly different from zero. However, the coefficient on the DOWN variable for the largest volume quintile is -1.75% for non-dividend-paying stocks and -0.63% for dividend-paying stocks; both are significant at the 1% level. Note also that the coefficients for the DOWN variable for the dividend-paying stocks across all volume quintiles are higher than any of the coefficients on the DOWN variable for non-dividend-paying stocks. Again, the magnitude of the difference between the coefficients on the DOWN variable for dividend-paying and non-dividend-paying stocks is monotonically increasing in volume (from -0.71% for the least liquid to -1.12% for the most liquid). These results indicate that the signaling explanation is more likely than a prospect theory explanation.

Insert Table 15 here

D. Summary of Results

Collectively these results support a signaling theory explanation more than prospect theory. Further, the signaling theory explanation is also supported by results in the previous sections. For example, the tests of dividend changes can be understood in the context of signaling theory: when firms cut dividends when the market is doing well, it is a clearer signal that they are having problems. However, if firms cut dividends when the market is doing poorly, there is less information in the dividend cut or the market may view the cut as an appropriate step by management to undertake given current economic conditions. Thus, the results in Table 7 reconfirm the earlier results that the asymmetric responses in up and down markets and provide further support for the dividend signaling hypothesis. Similarly, the results in Table 8 indicate not only that the dividend-payment is valued as a signal, but that even during the time periods when a dividend is not being paid (and thus no signal is being given), the mere knowledge that within three months a signal will be received is valued as well. Our results not only indicate that there is value in the signal of paying a dividend and not just the dividend payment itself, but also that there is a value in the knowledge that a signal will be received, further supporting the dividend signaling hypothesis.

V. Conclusion

Though anecdotal and academic research claims that dividends are disappearing, we find evidence that investors are concerned with firms’ dividend policies. Our results indicate that dividend-paying stocks outperform non-dividend-paying stocks by more in declining markets than in advancing ones. The results are robust to parametric and non-parametric tests. Further, these results hold when we control for risk (using CAPM, Fama-French three-factor model, and Fama-McBeth style regressions), different definitions of up and down markets, size, liquidity, and well as in subperiods. In addition, we show investors respond asymmetrically to dividend increases, decreases, and no changes based on the state of the market, and that dividend-paying firms outperform non-dividend paying firms even in the months with no dividend payments.

We also find that these results are not a function of dividend yield, but rather whether the firm pays a dividend at all. We find a much larger difference between the non-dividend-paying and low-dividend-yield portfolios than among the dividend-paying portfolios themselves, indicating more support for the signaling hypothesis than the prospect theory or the tax clientele/dividend capture hypothesis. Also, consistent with the signaling hypothesis, we find small dividend-paying firms and more liquid dividend-paying firms outperform their non-dividend-paying counterparts in down markets.

We conclude investors are not indifferent to dividend policy. Instead, they value dividends most highly in the states of the world and for those stocks where the signal provides the most value, i.e., in declining markets. While our overall results are consistent with both a behavioral explanation through prospect theory or a signaling explanation, further examination provides additional support for the dividend signaling literature in that we find that investors value dividends in a manner consistent with their valuing the signal. Risky firms that most need to signal are thus differentially rewarded, particularly during times of economic uncertainty. Overall, investors in dividend-paying stocks do better than investors in non-dividend-paying stocks, particularly in market downturns.

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|Table 1 |

|Summary Statistics |

| |

|Summary statistics for 21,488 NYSE, Amex and NASDAQ listed firms for the 372 calendar months from January 1970 to |

|December 2000. There are 2,161,688 firm months of which 1,392,422 are non-dividend-paying firm months and 769,266 are |

|dividend-paying firm months. Up Markets are the 217 months in our sample where the S&P 500 had a positive return; Down|

|Markets are the 155 months in our sample where the S&P 500 did not have a positive return. All data is from CRSP. |

|Monthly Volume is the average monthly trading volume, Price is the average end-of-the-month price per share, Market Cap|

|is the average end-of-the-month market capitalization, Dividend per share is the average quarterly dividend per share, |

|Beta is the average end-of-the-month CRSP estimate of beta, and Number of Obs is the total number of firm-months. |

| |Non-Dividend |Dividend |

| |Paying |Paying |

| |

|Panel A: All Markets (372 months) |

| Monthly Volume[24] |18,147 |20,476 |

| Price |$11.21 |$25.30 |

| Market Cap. |$288,530,530 |$1,321,917,830 |

| Dividend per share |None |$0.078 |

| Beta |0.733 |0.716 |

| Number of Obs. |1,392,422 |769,266 |

| | | |

|Panel B: Up Markets (217 months) |

| Monthly Volume |17,736 |21,340 |

| Price |$11.49 |$26.20 |

| Market Cap. |286,760,200 |1,411,436,090 |

| Dividend per share |None |$0.080 |

| Beta |0.725 |0.708 |

| Number of Obs. |846,677 |473,542 |

| | | |

|Panel C: Down Markets (155 months) |

| Monthly Volume |18,833 |19,183 |

| Price |$10.80 |$24.06 |

| Market Cap. |291,171,220 |1,175,653,940 |

| Dividend per share |None |$0.076 |

| Beta |0.744 |0.728 |

| Number of Obs. |545,745 |295,724 |

|Table 2 |

|Average Return for both Up and Down Markets |

| |

|The table reports the average monthly return to dividend- and non-dividend-paying stocks for the 372 calendar months from January 1970 to |

|December 2000. Up Markets are the 217 months in our sample where the S&P 500 had a positive return; Down Markets are the 155 months in our|

|sample where the S&P 500 did not have a positive return. Difference of Differences is the difference of non-dividend-paying stocks minus |

|dividend-paying stocks in up markets minus the difference of non-dividend-paying stocks minus dividend-paying stocks in down markets. |

| | | | | |

| | |Non-Dividend-paying |Dividend-paying |Differencea |

| | | | | |

|Panel A: All years |

| All Markets | |1.01% |1.38% |-0.37%**,w,k |

| | | | | |

| Up Markets | |3.72% |3.88% |-0.16%w,k |

| Down Markets | |-3.03% |-2.13% |-0.90%**,w,k |

| Difference Of Differences | | 0.74%** |

| | | | | |

| | | | | |

|Panel B: Subperiods |

| | | | | |

|1970s | | | | |

| All Markets | |1.07% |1.22% |-0.15%**,w,k |

| | | | | |

| Up Markets | |6.09% |5.26% | 0.83%**,w,k |

| Down Markets | |-3.02% |-2.55% |-0.47%**,w,k |

| Difference Of Differences | | 1.30%** |

| | | | | |

|1980s | | | | |

| All Markets | |0.84% |1.68% |-0.84%**,w,k |

| | | | | |

| Up Markets | |3.61% |4.26% |-0.65%**,w,k |

| Down Markets | |-3.26% |-2.03% |-1.23%**,w,k |

| Difference Of Differences | | 0.58%** |

| | | | | |

|1990s | | | | |

| All Markets | |1.10% |1.23% |-0.13%**,w,k |

| | | | | |

| Up Markets | |3.19% |2.76% | 0.43%**,w,k |

| Down Markets | |-2.87% |-1.70% |-1.17%*,w,k |

| Difference Of Differences | | 1.60%** |

a Significance was only tested using parametric tests for the Differences of Differences.

* indicates t-test is significant at the 5% level

** indicates t-test is significant at the 1% level

w indicates the Wilcoxon sign-rank test is significant at the 1% level

k indicates the Kruskal-Wallis test is significant at the 1% level

|Table 3 |

|CAPM Risk-Adjusted Abnormal Returns |

| |

|The table reports the average monthly abnormal return to dividend- and non-dividend-paying stocks for the 372 calendar months from |

|January 1970 to December 2000. Up Markets are the 217 months in our sample where the S&P 500 had a positive return; Down Markets are the|

|155 months in our sample where the S&P 500 did not have a positive return. Abnormal returns for each firm for each month were |

|calculated as: |

| |

|[pic] |

| |

|where Actual Returnf is the return for firm f for that month, rF is the three-month treasury bill for that month, rM is the return on the|

|CRSP equally-weighted portfolio, and βf is the beta for stock f. |

| | | | | |

| | |Non-Dividend-paying |Dividend-paying | |

| | |Abnormal Returns |Abnormal Returns |Differences |

| | | | | |

|All Markets | |0.14% |0.27% |-0.13%**,w,k |

| | | | | |

|Up Markets | |0.85% |0.66% |0.19%**,w,k |

| | | | | |

|Down Markets | |-0.90% |-0.30% |-0.60%**,w,k |

| | | | | |

|Difference of Differences a | | | |0.79%** |

a Significance was only tested using parametric tests for the Differences of Differences.

* indicates t-test is significant at the 5% level

** indicates t-test is significant at the 1% level

w indicates the Wilcoxon sign-rank test is significant at the 1% level

k indicates the Kruskal-Wallis test is significant at the 1% level

|Table 4 |

|Excess Returns for 16 Portfolios Formed on Size and BE/ME |

| |

|This table contains the excess returns for portfolios of dividend-paying and non-dividend-paying firms based on size and book-to-market of equity. Excess return, rit – rFt, is the return for a firm in month t |

|minus the three-month Treasury bill return in month t. The data is from CRSP and Compustat and runs from January 1980 to December 2000. Up markets are when the S&P 500 index return was greater than 0 and |

|down markets are when the S&P 500 index return was 0 or less. |

| | |Book – to – market quartiles |

| | |Low | |2 | |3 | |High |

|Size |

| | |Intercept |RMRF |SMB |HML |DOWN |Adjusted R2 |

| | | | | | | | |

|Panel A: Traditional Fama-French |

|Non-Dividend-paying | |-0.0016 |1.0054** |1.1211** |0.2761** | |89.4% |

|Dividend-paying | |0.0002 |0.9680** |0.4163** |0.5122** | |92.3% |

| Differences | | | |** |** | | |

| | | | | | | | |

|Panel B: Modified Fama-French for UP/DOWN Markets |

| | | | | | | | |

|Non-Dividend-paying | |0.0042* |0.9210** |1.0580** |0.2641** |-0.0134** |89.8% |

|Dividend-paying | |0.0015 |0.9497** |0.4027** |0.5096** |-0.0029 |92.3% |

| Differences | | | |** |** |** | |

| | | | | | | | |

* indicates t-test is significant at the 5% level

** indicates t-test is significant at the 1% level

|Table 6 |

|Fama-McBeth Returns |

| |

|This table contains the average coefficients of monthly ordinary least squares regressions of dividend-paying and non-dividend-paying firms. The|

|regressions were run cross-sectionally each month for every firm as in Fama and McBeth (1972). The coefficients reported below are the average |

|coefficients for each group. The regressions are of the form: |

| |

|[pic] |

| |

|where rit – rFt is the return on a stock in month t minus the three-month Treasury bill return for month t, [pic] is the firm’s beta measured for|

|the prior year for month t, Ln(Mktcap) is the natural log of the firm’s market capitalization for month t, Ln(BVEquity) is the natural log of the|

|firm’s book value of equity for month t, and DIV is an indicator variable that equals one if the firm pays a dividend in month t and zero if the |

|firms does not pay a dividend in month t. The data is from CRSP and Compustat and runs from January 1970 to December 2000. Up markets are when |

|the S&P 500 index return was greater than 0 and down markets are when the S&P 500 index return was 0 or less. |

| | |Intercept |[pic] |Ln(Mktcap) |Ln(BVEquity) |DIV |

|Down Markets | |-0.0201 |0.7803 |4.1177 |0.3817 |0.3759 |

|Up Markets | |0.0049 |0.7563 |4.3412 |0.5219 |0.3608 |

| Differences | |** |** |** |** |** |

* indicates t-test is significant at the 5% level

** indicates t-test is significant at the 1% level

|Table 7 |

|Cumulative Abnormal Returns for Dividend Changes in Up and Down Markets |

| |

|Cumulative abnormal returns (CAR) are calculated for the five days (-2, 2) around the announcement (day 0) of a dividend change. Abnormal |

|returns are estimated using a modified market model |

|[pic] |

|where ri is the return on firm i and rm is the equally-weighted market index return. The usual estimation period is eliminated due to the |

|high probability of previous dividend changes for firms during the estimation period. The CARs for 18,537 increases, 4,595 decreases, and |

|93,537 no changes announced between 1970 to 2000 for 3,294 firms are reported for all markets, up markets, and down markets. Up markets are|

|when the S&P 500 index return was greater than 0 and down markets are when the S&P 500 index return was 0 or less. |

|Panel A: All Markets |

| |Dividend Increase |Dividend Decrease |No Change |

| |1.013%** |-0.360%** |0.102%** |

|Panel B: Up and Down Markets |

| |Up Markets |Down Markets |Difference |

| | | |(Up – Down ) |

|Dividend Increase |0.857%** |1.206%** |-0.349%*,w,k |

|Dividend Decrease |-0.375%** |-0.324%* |-0.051%w,k |

|No Change |0.046% |0.170%** |-0.124%**,w,k |

* indicates t-test is significant at the 5% level

** indicates t-test is significant at the 1% level

w indicates the Wilcoxon sign-rank test is significant at the 1% level

k indicates the Kruskal-Wallis test is significant at the 1% level

|Table 8 |

|Average Return for Up and Down Markets |

|for Dividend-Paying Stocks during Months with No Dividend Payments |

| |

|The table reports the average monthly return to dividend- and non-dividend-paying stocks from 1970 to 2000. Dividend-paying stocks are only |

|included for months during which a quarterly dividend-paying stock did not pay a dividend. Up markets are when the S&P 500 index return was greater|

|than 0 and down markets are when the S&P 500 index return was 0 or less. Overall, there were 217 up months and 155 down months in our sample. |

|Average monthly returns are reported for all stocks and for firms classified by their CRSP beta deciles. |

|Panel A – Returns |

| |

| | |Up Markets | |Down Markets | | |

| |

| |

| | |Intercept |RMRF |SMB |HML |DOWN |Adjusted R2 |

| | | | | | | | |

|Non-Dividend-paying | |0.0042* |0.9210** |1.0580** |0.2641** |-0.0134** |89.8% |

|Dividend-paying | |-0.0008 |0.9527** |0.4036** |0.5161** |-0.0028 |92.1% |

| Differences | |* | |** |** |** | |

| | | | | | | | |

a Significance was only tested using parametric tests for the Differences of Differences.

* indicates t-test is significant at the 5% level

** indicates t-test is significant at the 1% level

w indicates the Wilcoxon sign-rank test is significant at the 1% level

k indicates the Kruskal-Wallis test is significant at the 1% level

|Table 9 |

|Fama-French Risk Adjusted Returns Removing Smallest (and Largest) Firms |

| |

|This table contains the coefficients of ordinary least squares regressions across equal-weighted portfolios of dividend-paying and |

|non-dividend-paying firms. The regressions are of the form: |

| |

|[pic] |

| |

|where rit – rFt is the return on a equal-weighted portfolio of either dividend or non-dividend-paying stocks in month t minus the |

|three-month Treasury bill return in month t, RMRF is the excess return on a value-weighted aggregate market proxy for month t, SMB is the |

|difference in the returns of a value-weighted portfolio of small stocks and large stocks for month t, HML is the difference in the returns |

|of a value-weighed portfolio of high book-to-market stocks and low book-to-market stocks for month t, and DOWN is an indicator variable that|

|equals one if the market is down and zero if the market is up. The data is from CRSP and runs from January 1970 to December 2000. Up |

|markets are when the S&P 500 index return was greater than 0 and down markets are when the S&P 500 index return was 0 or less. |

| | |Intercept |RMRF |SMB |HML |DOWN |Adjusted R2 |

| | | | | | | | |

|Panel A: Fama-French Risk Adjusted Returns removing Smallest 25% |

|Non-Dividend-paying | |0.0106** |1.0606** |1.0015** |0.1837** |-0.0081** |94.6% |

|Dividend-paying | |0.0021* |0.9703** |0.3794** |0.5099** |-0.0029 |92.3% |

| Differences | |** |** |** |** |* | |

| | | | | | | | |

|Panel B: Fama-French Risk Adjusted Returns for Middle 50% |

|(Deleted Smallest 25% and Largest 25%) |

| | | | | | | | |

|Non-Dividend-paying | |0.0102** |1.0561** |1.0844** |0.2703** |-0.0110** |92.3% |

|Dividend-paying | |0.0001 |0.8955** |0.6339** |0.6026** |-0.0022 |90.4% |

| Differences | |** |** |** |** |** | |

* indicates t-test is significant at the 5% level

** indicates t-test is significant at the 1% level

|Table 10 |

|Returns for both Bull and Bear Markets |

| |

|The table reports the average monthly return to dividend- and non-dividend-paying stocks in bull and bear markets from 1970 to 2000. Bull and bear markets are |

|defined by Ned Davis research. Overall, there were 259 bull months and 113 bear months in our sample. Average monthly returns are reported for all stocks |

|and for firms classified by their CRSP beta deciles. Fama-French regressions are of the form: |

|[pic] |

| |

|where rit – rFt is the return on a equally-weighted portfolio of either dividend or non-dividend-paying stocks in month t minus the three-month Treasury bill |

|return in month t, RMRF is the excess return on a value-weighted aggregate market proxy for month t, SMB is the difference in the returns of a value-weighted |

|portfolio of small stocks and large stocks for month t, HML is the difference in the returns of a value-weighed portfolio of high book-to-market stocks and low|

|book-to-market stocks for month t, and DOWN is an indicator variable that equals one if the market is a bear market and zero if the market is a bull market. |

|The data is from CRSP and runs from January 1970 to December 2000. |

|Panel A: Univariate Results |

| | | |Up Markets | | | |Down Markets | | |

| |

| | | |Intercept |RMRF |SMB |HML |DOWN |Adjusted R2 | |

| | | | | | | | | |

|Non-Dividend-paying |0.0000 |0.9885** |1.1225** |0.2808** |-0.0051 |89.5% | |

| | | | | | |92.3% | |

|Dividend-paying |0.0008 |0.9623** |0.4168** |0.5138** |-0.0017 | | |

| Differences | | |** |** |* | | | |

a Significance was only tested using parametric tests for the Differences of Differences.

* indicates t-test is significant at the 5% level

** indicates t-test is significant at the 1% level

w indicates the Wilcoxon sign-rank test is significant at the 1% level

k indicates the Kruskal-Wallis test is significant at the 1% level

|Table 11 |

|Fama-French Risk Adjusted Returns Controlling for Volatility |

| |

|This table contains the coefficients of ordinary least squares regressions across equally-weighted portfolios of dividend-paying and |

|non-dividend-paying firms. The regressions are of the form: |

| |

|[pic] |

| |

|where rit – rFt is the return on a equally-weighted portfolio of either dividend or non-dividend-paying stocks in month t minus the three-month |

|Treasury bill return in month t, RMRF is the excess return on a value-weighted aggregate market proxy for month t, SMB is the difference in the |

|returns of a value-weighted portfolio of small stocks and large stocks for month t, HML is the difference in the returns of a value-weighed |

|portfolio of high book-to-market stocks and low book-to-market stocks for month t, DOWN is an indicator variable that equals one if the market is |

|down and zero if the market is up, and VOL is an indicator variable that equals one if the market has high volatility and zero if the market has |

|low volatility. The data is from CRSP and the CBOE and runs from January 1986 to December 2000. Up markets are when the S&P 500 index return was |

|greater than 0 and down markets are when the S&P 500 index return was 0 or less. |

| | |Intercept |RMRF |SMB |HML |DOWN |VOL |Adjusted R2 |

| | | | | | | | | |

|Panel A: Including 1986 and 1987 data |

|Non-Dividend-paying | |0.0088** |0.8159** |0.8162** |0.1731** |-0.0222** |-0.0024 |86.9% |

|Dividend-paying | |-0.0022 |0.9057** |0.2974** |0.6364** |-0.0027 |-0.0045 |90.5% |

| Differences | |** | |** |** |** | | |

| |

|Panel B: Excluding 1986 and 1987 data |

|Non-Dividend-paying | |0.0112** |0.7498** |0.7706** |0.1501* |-0.0277** |-0.0011 |84.8% |

|Dividend-paying | |-0.0013 |0.8632** |0.2773** |0.6497** |-0.0045 |-0.0006 |88.2% |

| Differences | |** | |** |** |** | | |

* indicates t-test is significant at the 5% level

** indicates t-test is significant at the 1% level

|Table 12 |

|Fama-French Risk Adjusted Returns Controlling for NYSE and NASDAQ |

| |

|This table contains the coefficients of ordinary least squares regressions across value-weighted portfolios of dividend-paying and |

|non-dividend-paying firms by exchange listing, either NYSE or NASDAQ. The regressions are of the form: |

| |

|[pic] |

| |

|where rit – rFt is the return on a equally-weighted portfolio of either dividend or non-dividend-paying stocks listed on the NYSE/AMEX |

|(NASDAQ) exchange in month t minus the three-month Treasury bill return in month t, RMRF is the excess return on a value-weighted aggregate |

|market proxy for month t, SMB is the difference in the returns of a value-weighted portfolio of small stocks and large stocks for month t, |

|HML is the difference in the returns of a value-weighed portfolio of high book-to-market stocks and low book-to-market stocks for month t, |

|and DOWN is an indicator variable that equals one if the market is down and zero if the market is up. The data is from CRSP and runs from |

|January 1970 to December 2000. Up markets are when the S&P 500 index return was greater than 0 and down markets are when the S&P 500 index |

|return was 0 or less. |

| | |Intercept |RMRF |SMB |HML |DOWN |AdjustedR2 |

| | | | | | | | |

|Panel A: NYSE/AMEX Stocks |

|Non-Dividend-paying | |-0.0003 |1.1219** |0.9474** |0.5791** |-0.0054** |89.9% |

|Dividend-paying | |0.0009 |1.0232** |0.3490** |0.5051** |-0.0028 |92.1% |

| Differences | | |** |** | |* | |

| | | | | | | | |

|Panel B: NASDAQ Stocks |

|Non-Dividend-paying | |0.0070** |0.7804** |1.1430** |0.0709 |-0.0192** |85.3% |

|Dividend-paying | |0.0023 |0.7965** |0.5419** |0.5279** |-0.0047 |84.5% |

| Differences | |** | |** |** |** | |

| | | | | | | | |

|Panel C: Dividend-paying NYSE/AMEX vs. Dividend-paying NASDAQ Stocks |

|NYSE/AMEX | |0.0009 |1.0232** |0.3490** |0.5051** |-0.0028 |92.1% |

|NASDAQ | |0.0023 |0.7965** |0.5419** |0.5279** |-0.0047 |84.5% |

| Differences | | |** |** | | | |

* indicates t-test is significant at the 5% level

** indicates t-test is significant at the 1% level

|Table 13 |

|Fame-French Risk Adjusted Returns Partitioned by Dividend Yield |

| |

|This table contains the coefficients of ordinary least squares regressions across equal-weighted portfolios of dividend-paying and |

|non-dividend-paying firms. The regressions are of the form: |

| |

|[pic] |

| |

|where rit – rFt is the return on a equal-weighted portfolio of either dividend or non-dividend-paying stocks in month t minus the |

|three-month Treasury bill return in month t, RMRF is the excess return on a value-weighted aggregate market proxy for month t, SMB is the |

|difference in the returns of a value-weighted portfolio of small stocks and large stocks for month t, HML is the difference in the returns |

|of a value-weighed portfolio of high book-to-market stocks and low book-to-market stocks for month t, and DOWN is an indicator variable that|

|equals one if the market is down and zero if the market is up. The data is from CRSP and runs from January 1970 to December 2000. Up |

|markets are when the S&P 500 index return was greater than 0 and down markets are when the S&P 500 index return was 0 or less. |

| | |Intercept |RMRF |SMB |HML |DOWN |Adjusted R2 |

| | | | | | | | |

|Panel A: Dividend Yield Comparisons |

| | | | | | | | |

|Lowest dividend yield | |0.0092** |1.1117** |0.4625** |0.2911** |-0.0067* |89.7% |

|2 | |0.0028* |1.0520** |0.4504** |0.5183** |-0.0034 |89.9% |

|3 | |-0.0001 |0.9885** |0.4352** |0.5839** |-0.0013 |90.7% |

|4 | |-0.0020 |0.8990** |0.3864** |0.5982** |-0.0021 |90.6% |

|Highest dividend yield | |-0.0025* |0.6985** |0.2804** |0.5568** |-0.0008 |85.0% |

| Differences | |** |** |** |** | | |

| | | | | | | | |

|Panel B: Comparison of non-dividend-paying and lowest yielding stocks |

| | | | | | | | |

|Non-Dividend-paying | |0.0042* |0.9210** |1.0580** |0.2641** |-0.0134** |89.8% |

|Lowest dividend yield | |0.0092** |1.1117** |0.4625** |0.2911** |-0.0067* |89.7% |

| Differences | | |** |** | |* | |

* indicates t-test is significant at the 5% level

** indicates t-test is significant at the 1% level

|Table 14 |

|Fame-French Risk Adjusted Returns by Size |

| |

|This table contains the coefficients of ordinary least squares regressions across value-weighted portfolios of dividend-paying and non-dividend-paying firms by |

|size groups. The regressions are of the form: |

| |

|[pic] |

| |

|where rit – rFt is the return on a equally-weighted portfolio of either dividend or non-dividend-paying stocks in month t minus the three-month Treasury bill |

|return in month t, RMRF is the excess return on a value-weighted aggregate market proxy for month t, SMB is the difference in the returns of a value-weighted |

|portfolio of small stocks and large stocks for month t, HML is the difference in the returns of a value-weighed portfolio of high book-to-market stocks and low |

|book-to-market stocks for month t, and DOWN is an indicator variable that equals one if the market is down and zero if the market is up. The data is from CRSP and|

|runs from January 1970 to December 2000. Up markets are when the S&P 500 index return was greater than 0 and down markets are when the S&P 500 index return was 0 |

|or less. |

| | | |Intercept |RMRF |SMB |HML |DOWN | |Adjusted R2 |

|Smallest |Non-Dividend-paying | |-0.0066* |0.6832** |1.1378** |0.4174** |-0.0232** | |72.5% |

| |Dividend-paying | |-0.0086** |0.6386** |0.6971** |0.5888** |-0.0020 | |72.4% |

| | Differences | | | |** |** |** | | |

| | | | | | | | | | |

|2 |Non-Dividend-paying | |0.0088** |1.0041** |1.1790** |0.4024** |-0.0146** | |87.6% |

| |Dividend-paying | |-0.0011 |0.8165** |0.6968** |0.6594** |-0.0034 | |86.0% |

| | Differences | |** |** |** |** |** | | |

| | | | | | | | | | |

|3 |Non-Dividend-paying | |0.0121** |1.1170** |0.9391** |0.0981** |-0.0068** | |95.1% |

| |Dividend-paying | |0.0008 |0.9433** |0.5972** |0.5701** |-0.0011 | |91.1% |

| | Differences | |** |** |** |** |* | | |

| | | | | | | | | | |

|Largest |Non-Dividend-paying | |0.0134** |1.0339** |0.6000** |-0.1601** |-0.0003 | |93.2% |

| |Dividend-paying | |0.0043** |1.0348** |0.0924** |0.4034** |-0.0041 | |91.5% |

| | Differences | |** | |** |** | | | |

* indicates t-test is significant at the 5% level

** indicates t-test is significant at the 1% level

|Table 15 |

|Fame-French Risk Adjusted Returns by Volume |

| |

|This table contains the coefficients of ordinary least squares regressions across value-weighted portfolios of dividend-paying and non-dividend-paying firms by |

|volume groups. The regressions are of the form: |

| |

|[pic] |

| |

|where rit – rFt is the return on a equally-weighted portfolio of either dividend or non-dividend-paying stocks in month t minus the three-month Treasury bill |

|return in month t, RMRF is the excess return on a value-weighted aggregate market proxy for month t, SMB is the difference in the returns of a value-weighted |

|portfolio of small stocks and large stocks for month t, HML is the difference in the returns of a value-weighed portfolio of high book-to-market stocks and low |

|book-to-market stocks for month t, and DOWN is an indicator variable that equals one if the market is down and zero if the market is up. The data is from CRSP |

|and runs from January 1970 to December 2000. Up markets are when the S&P 500 index return was greater than 0 and down markets are when the S&P 500 index return |

|was 0 or less. |

| | | |Intercept |RMRF |SMB |HML |DOWN | |Adjusted R2 |

|Lowest |Non-Dividend-paying | |-0.0122** |0.7230** |0.8198** |0.4980** |-0.0065 | |74.1% |

| |Dividend-paying | |-0.0033** |0.6731** |0.5251** |0.5123** |0.0006 | |82.1% |

| | Differences | |** | |** | |* | | |

| | | | | | | | | | |

|2 |Non-Dividend-paying | |-0.0111** |0.9953** |1.1023** |0.7269** |-0.0069 | |83.3% |

| |Dividend-paying | |-0.0027** |0.9083** |0.6354** |0.6260** |0.0006 | |88.8% |

| | Differences | |** |* |** |* |* | | |

| | | | | | | | | | |

|3 |Non-Dividend-paying | |0.0015 |1.0813** |1.1926** |0.5375** |-0.0113** | |86.7% |

| |Dividend-paying | |0.0014 |1.0122** |0.5680** |0.5939** |-0.0014 | |90.8% |

| | Differences | | | |** | |** | | |

| | | | | | | | | | |

|4 |Non-Dividend-paying | |0.0156** |1.1656** |1.1928** |0.2320** |-0.0151** | |90.5% |

| |Dividend-paying | |0.0047** |1.0829** |0.3790** |0.5246** |-0.0050 | |89.9% |

| | Differences | |** | |** |** |** | | |

| | | | | | | | | | |

|Highest |Non-Dividend-paying | |0.0312** |1.2073** |1.2567** |-0.1641** |-0.0175** | |90.1% |

| |Dividend-paying | |0.0057** |1.1313** |0.0405 |0.3627** |-0.0063** | |91.6% |

| | Differences | |** | |** |** |* | | |

| | | | | | | | | | |

| | | | | | | | | | |

* indicates t-test is significant at the 5% level

** indicates t-test is significant at the 1% level

-----------------------

[1] A third reason why investors would prefer cash dividends, the theory of self-control, was developed by Thaler and Shefrin (1981). As discussed in Shefrin and Statman (1984) , investors may want to consume dividend payments so to keep from consuming their long-run wealth (i.e., consuming capital). However, the theory of self-control cannot explain differential investor preferences based on market movements.

[2] Markowitz (1952, 1959) noted that investors may care about downside risk differentially. Other theories, such as first-order risk aversion utility functions in Gul (1991), provide a similar result.

[3] Dividends either signal managers’ private information regarding future earnings [e.g., Bhattacharya (1979), John and Williams (1985), and Miller and Rock (1985)] or signal that managers will not waste excess cash [e.g., Easterbrook (1984), Jensen (1986), and Lang and Litzenberger (1989)]. As noted in Allen and Michaely (2004), empirical tests of these two hypotheses fail to pick an overwhelming winner. Brav, Graham, Harvey, and Michaely (2004) find that managers believe dividends do signal information but are not sure exactly what is being signaled. We do not attempt to distinguish between these two theories of dividend signaling.

[4] As Frankel and Froot (1990, p. 182) note “The tremendous volume of … trading is another piece of evidence that reinforces the idea of heterogenenous expectations, sinceit takes differences among market participants to explain why they trade.”

[5] See Clements (2002) for a larger discussion on this point. Recent changes in tax laws have also reduced or eliminated the tax benefits of capital gains over dividend payments.

[6] For example, if a stock pays dividends in March, June, September, and December, the non-dividend-paying months are January, February, April, May, July, August, October, and November. While Easterbrook (1984) noted that “designing an empirical test [of constant-payout policies] is formidable,” Section V provides an empirical test of dividend-paying firms in non-dividend-paying months to examine the benefit of such constant dividend-payout policies.

[7] Baker and Wurgler (2004) find some evidence that when investors value dividends, managers will initiate dividend payments and when investors value non-dividend-paying stocks, manager omit dividend payments.

[8] To insure that these rules did not affect our results, we re-ran our tests using alternate definitions of dividend-paying stocks. For example, we also included all regularly scheduled dividend payments (monthly, quarterly, and yearly) when classifying firms as dividend-paying. As another alternative classification method, we dropped all non-quarterly-dividend payments from the sample so non-dividend-paying firms never paid any type of cash dividend. Results are qualitatively similar and available upon request.

[9] As a robustness check, we also ran the results requiring that for a firm to be called a dividend-paying firm, the firm must pay dividends for the entire time period. All of the results were substantively unchanged.

[10] As one area of concern is the response of dividend-paying stocks, we chose a classification method that, if anything, will bias downwards the returns of dividend-paying stocks. In particular, this classification method does not bias upward the results for the dividend-paying stocks due to initiations and omissions.

[11]As a robustness check, we also ran tests defining down markets as negative excess returns. The results on excess returns (not reported here) are substantively similar. In the robustness section, we classified up and down markets based on bull and bear market definitions provided by Ned Davis Research Inc.

[12] The difference of differences used throughout the paper is the difference of non-dividend-paying stocks minus dividend-paying stocks in up markets minus the difference of non-dividend-paying stocks minus dividend-paying stocks in down markets. A positive number for this test indicates that dividend-paying stocks outperformed non-dividend-paying stocks by more in down markets than in up markets. Throughout the paper, only parametric methods were used to test the significance of the difference of difference test due to the nature of the data (unequal number of observations across all four potential categories).

[13] We thank Ken French for providing the cutoff points for the market capitalization and book-to-market quartiles.

[14] To determine if the results in Table 4 were driven by differences in size and book-to-market values for dividend-paying versus non-dividend-paying stocks within each individual size and book-to-market subgrouping, we examined the median size and book-to-market values for each group in the sixteen groupings.  We found that only for the smallest firms were there significant differences between the median size of dividend-paying and non-dividend-paying firms (dividend paying firms were significantly larger than non-dividend-paying firms). There were no significant differences in median book-to-market ratios for dividend-paying and non-dividend-paying firms across the sixteen groups.

[15] We also changed the definition of up/down markets to be based on whether the CRSP equally-weighted index had positive returns or not. The results provided even more support that dividend-paying stock outperform non-dividend-paying stocks even when portfolio returns were value-weighted.

[16] For example, since the value-weighted dividend-paying portfolio returns are highly correlated with the S&P 500 return, we would expect that dividend-paying portfolios to always do worse than non-dividend-paying firms in down markets.

[17] Asquith and Mullins (1983), Healy and Palepu (1988), and Michaely, Thaler and Womack (1995) show that there are more pronounced market reactions to dividend initiation and omission announcements than there are to dividend changes. Therefore, to be conservative, we exclude initiations and omissions to ensure that our results are not the result of initiations or omissions but are solely due to changes.

[18] Similarly, any asset pricing strategy that involves dividend capture or tax clienteles should not have different results in non-dividend-paying months.

[19] Similarly, these results would be true if there were an asset pricing or tax effect.

[20] In addition, if the results found in this paper were due to an asset pricing result, it should be true that dividend yields are positively associated with differences in returns in up and down markets.

[21] Again, we are not suggesting that each individual dividend payment has great signaling value, but that the regular payment of a dividend sends a signal as does increasing or decreasing a dividend. In addition, investors know when to expect this signal. Alternatively, from a prospect theory perspective, the two tests examine different parts of the loss avoidance that makes investors prefer a certain gain: is it the level of certainty (similar to the signaling theory) or the size of the gain (similar to the asset pricing theory)?

[22] As Frankel and Froot (1990, p. 182) note “The tremendous volume of … trading is another piece of evidence that reinforces the idea of heterogenenous expectations, since it takes differences among market participants to explain why they trade.”

[23] See also Varian (1985) and Shalen (1993) for a discussion of differences in opinion, volume and prices.

[24] The number of volume observations is less than other variables since some months no volume was reported on CRSP. Instead of throwing out that entire observation for the month when no volume was reported, we simply ignored those observations when computing the average monthly volume.

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