Do Dividends Matter more in Declining Markets?

Kathleen FullerTerry 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: G35Keywords: 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,

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.

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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

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.

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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

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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.

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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

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.”

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for the results found in this paper. Section VII concludes.

I. 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

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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.

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.

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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

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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 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.

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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.

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.

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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.

II. 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

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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

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.

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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-

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.11As 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.

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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

III. 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-

14

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

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).

15

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:

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

16

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

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

17

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:

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.

18

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

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

19

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,

markets.

20

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

21

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:

where rit – rFt is the return on a stock in month t minus the three-month Treasury bill return for month t,

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

22

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.-

23

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:

(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-

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.

24

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

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

25

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 (-

26

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.

IV. 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

27

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.

28

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

29

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:

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

30

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

31

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

V. 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

32

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

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)?

33

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

34

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

35

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

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.”

36

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.

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

37

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.

VI. 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

38

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.

39

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43

Table 1Summary 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-DividendPaying

DividendPaying

Panel A: All Markets (372 months) Monthly Volume24 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

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.

44

Table 2Average 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% levelw indicates the Wilcoxon sign-rank test is significant at the 1% levelk indicates the Kruskal-Wallis test is significant at the 1% level

45

Table 3CAPM 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:

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-payingAbnormal 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% levelw indicates the Wilcoxon sign-rank test is significant at the 1% levelk indicates the Kruskal-Wallis test is significant at the 1% level

46

Table 4Excess 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, r it – 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 quartilesLow 2 3 High

Size Non-Div.

Div. Difference Non-Div.

Div. Difference Non-Div.

Div. Difference Non-Div.

Div. Difference

Panel A: All MarketsSmall 2.14% 2.29% -0.15%,w,k 0.54% 1.43% -0.89%**,w,k -0.20% 0.72% -0.92%**,w,k -2.00% -0.90% -1.10%**,w,k

2 3.48 2.01 1.47**,w,k 1.33 1.23 0.10 0.26 0.42 -0.16w,k -1.20 -1.30 0.103 3.92 1.85 2.07**,w,k 1.38 1.11 0.27 0.23 0.29 -0.06 -0.80 -1.20 0.40Large 3.86 1.84 2.02**,w,k 1.31 1.16 0.15 0.69 0.34 0.35w,k -0.40 -0.70 0.30

Panel B: Up MarketsSmall 4.64 4.21 0.43**,w,k 2.64 2.93 -0.29**,w,k 1.71% 1.88% -0.17 w,k -0.16 0.59 -0.75**,w,k

2 6.51 4.14 2.37**,w,k 3.93 3.03 0.90**,w,k 2.89% 2.23% 0.66**,w,k 2.28 1.37 0.91**,w,k

3 6.87 4.17 2.70**,w,k 3.90 3.08 0.82**,w,k 2.68% 2.43% 0.25 2.03 1.77 0.26Large 7.15 4.11 3.04**,w,k 3.74 3.36 0.38 2.60% 2.61% -0.01 2.43 2.57 -0.14

Panel C: Down MarketsSmall -2.28 -1.14 -1.14**,w,k -3.25 -1.29 -1.96**,w,k -3.69% -1.42% -2.27**,w,k -5.05 -3.37 -1.68**,w,k

2 -2.25 -1.82 -0.43*,w,k -3.31 -2.02 -1.29**,w,k -4.36% -2.57% -1.79**,w,k -6.93 -5.30 -1.63**,w,k

3 -1.98 -2.29 0.31 -2.98 -2.46 -0.52*,w,k -3.85% -3.37% -0.48 -5.45 -5.66 0.21Large -1.89 -2.39 0.50* -2.79 -2.80 0.01 -2.11% -3.50% 1.39**,w,k -4.76 -5.47 0.71

Panel D: Differences of Differences (Up – Down )a

1.57** 1.67** 2.10** 0.93**

2.80** 2.19** 2.45** 2.54**

2.39** 1.34** 0.73* 0.052.54** 0.37 -1.40** -0.85

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% levelw indicates the Wilcoxon sign-rank test is significant at the 1% level k indicates the Kruskal-Wallis test is significant at the 1% level

47

Table 5Fama-French Adjusted Returns

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:

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: 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

48

Table 6Fama-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:

where rit – rFt is the return on a stock in month t minus the three-month Treasury bill return for month t, 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 Ln(Mktcap) Ln(BVEquity) DIV

Down Markets -0.0201 0.7803 4.1177 0.3817 0.3759Up 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

49

Table 7Cumulative 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

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 MarketsDividend Increase Dividend Decrease No Change

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

Panel B: Up and Down MarketsUp 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% levelw indicates the Wilcoxon sign-rank test is significant at the 1% levelk indicates the Kruskal-Wallis test is significant at the 1% level

50

Table 8

Average Return for Up and Down Marketsfor 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 MarketsNon-Dividend-paying

Dividend-paying

Difference Non-Dividend-paying

Dividend-paying

Difference Differenceof Differencesa

All Stocks

3.72% 3.72% 0.00% -3.03% -2.36% -0.67%**, w,k 0.67%**

Panel B – Fama-French Regressions

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% levelw indicates the Wilcoxon sign-rank test is significant at the 1% levelk indicates the Kruskal-Wallis test is significant at the 1% level

51

Table 9Fama-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:

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

52

Table 10Returns 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:

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 ResultsUp Markets

Down Markets

Non-Dividend-paying

Dividend-paying

Difference Non-Dividend-paying

Dividend-paying

Difference Differenceof differencesa

2.09% 2.23% -0.14%**, w,k -2.37% -0.53% -1.84%,w, k 1.70%**

Panel B: Fama-French RegressionsIntercept RMRF SMB HML DOWN Adjusted R 2

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% levelw indicates the Wilcoxon sign-rank test is significant at the 1% levelk indicates the Kruskal-Wallis test is significant at the 1% level

53

Table 11Fama-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:

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

54

Table 12Fama-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:

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

55

Table 13Fame-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:

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

56

Table 14Fame-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:

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

57

Table 15Fame-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:

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

58