The markets are facing a number of cross-currents, including volatile oil prices, mixed economic data, and a weak U.S. dollar.

Adding to the mix, December is typically a time when stocks reflect concerns about fourth-quarter and year-end results. At this time of the year, stocks are also volatile since investors often seek to offset their gains and trim their taxes by selling losing positions.

December started with a bang, as crude oil prices plunged more than $5 a barrel during the first two days of the month, ending the week down -14%. The drop fuelled a sharp rally in stocks, as the reduced prices spurred hopes for a solid economic recovery. But the rally sputtered the next week when OPEC agreed to reduce output and prices began creeping higher.

Mixed economic signals are also keeping investors jittery about the market's potential future direction. A report that the U.S. economy created fewer-than-expected new jobs in the past three months raised concerns of an economic slowdown. In addition, a sharper-than-expected rise in wholesale prices triggered inflation fears that further spooked the markets.

Also weighing on the markets is the weak U.S. dollar. In the past year and a half, the dollar has lost about a third of its value against the world's major currencies, mainly on concerns over the funding of the huge U.S. trade gap. The dollar fell to an all-time low against the euro and a five-year low against the Japanese yen early in December but has since strengthened. The problem is if the dollar needs to be propped up with higher interest rates, then stocks might appear less attractive than risk-free Treasuries. 

On Friday, December 10th the market closed down about three points from the start of the month, with the S&P 500 finishing at 1188.00. The Dow Jones Select Dividend Index (^DJJ) paced the broader market, declining 16 points from December 1st and 19 points off its record high on November 15th. The index closed Friday at 699.65. Meanwhile, the Dow Jones Equity REIT Index (^DJR) closed on December 10th at a record high of 228.04, buoyed by continued low interest rates. 

While dividend indices hit new highs, yields on U.S. Treasuries have been falling on the mixed economic signals. Traders expect the Federal Reserve to raise short-term interest rates by a quarter of a percentage point to 2.25% on December 14th. But rates are also expected to remain relatively low over the coming year. The yield on the benchmark 10-year Treasury dropped a stunning 13 basis points after November's low employment numbers were reported, finishing at 4.16% on Friday, December 10th.



LOOKING AHEAD
Income stocks have delivered market-beating returns this year, and there are reasons to believe their performance could get even better in the year ahead.

From January through November 30th, dividend payers in the S&P 500 posted a total return of +14.4% versus just +7.8% for non-payers. The strong performance of dividend stocks stems from the double-barreled gains they have enjoyed in both dividend payments and share price appreciation. 

So far this year, almost half of the components of the S&P 500 have boosted their payouts and 10 have introduced their first-ever dividends. At the same time, many dividend payers have reached fresh all-time highs during the year.



Will the good times continue?
With many dividend-paying stocks now trading at lofty P/E multiples, we do not expect major share price gains from this group in the coming months. Instead, we expect higher-yielding dividend stocks to provide the best overall returns thanks to steadily rising dividend payouts. 

Given that more companies announce dividend increases in January or February than in any other months, we can expect to see a surge of higher payments in the coming months. The longer-term outlook for higher dividend payments is also optimistic, given that current dividend payouts are at rock bottom levels compared to their historical norms.

The market's current dividend yield of about 2% is only half of the 4.1% yield the S&P 500 has averaged for over the past 75 years. Since companies in the S&P 500 are now paying out less than 30% of their earnings in the form of dividends, there's plenty of room to lift their yields closer to the historical norm. Despite the recent dividend increases by many companies, payout levels are still at rock bottom levels compared to the 60-year average of 50% to 60% of earnings.

The market is now trading at a price-to-earnings (P/E) multiple of about 18X the past year's earnings -- in line with the 25-year average. Given that the market appears to be fairly priced and that corporate earnings are expected to grow by less than +10% next year, we are unlikely to see a period of rapidly rising share prices anytime soon. With this in mind, it seems clear that investing in stocks which offer the possibility of rising dividend payments, as well as modest share price appreciation, is a sure way to enhance returns.

Important Note:  To view the remainder of this Mid-Month Update, in which Carla Pasternak provides an in-depth analysis of dozens of her favorite income-oriented stocks and funds,  you'll need to subscribe to our premium High-Yield Investing newsletter.  Please visit one of the following links to continue...

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