Dividends Are Back -- For Now

Long before there were any true signs of life in the economy, stocks started their year-long advance based solely on faith in the future. Now it's time for bulls to put up or shut up. At least so far, there are promising signs to back up last year's belief that things could only get better.

Good news on the dividend front
One of the bright spots comes from stock dividends. Bloomberg recently did its regular analysis of dividend expectations, and its findings included something we haven't seen for six years: The news service forecasts that not a single member of the S&P 500 will have to cut its dividend during the second quarter.

That's welcome news in light of a disastrous 2009 for dividend investors. The number of S&P 500 stocks that decreased their dividend payouts in 2009 multiplied sixfold to 78. Largely because of problems in the first part of the year, the net decrease in total dividends paid during 2009 fell by a whopping $52.6 billion, or 21% less than 2008. That's the second-worst percentage drop in history, and the worst since the tail-end of the Great Depression in 1938.

In stark contrast, dividend increases are coming fast and furious this earnings season. So far this week, we've seen hikes from ExxonMobil (NYSE: XOM  ) , IBM (NYSE: IBM  ) , and Chevron (NYSE: CVX  ) , all of which are among the top 12 largest stocks in the U.S. stock market.

Letting the money flow
What's behind higher payouts? Look no further than the amazing gains we've seen so far on the earnings front. Although earnings during last year's first quarter were abysmal in the aftermath of the market meltdown, S&P 500 earnings for the current earnings season are projected to more than double. Perhaps more importantly, S&P estimates that first-quarter earnings will exceed levels from two years ago -- an important milestone toward getting the economy back on an even keel. At that rate, the index won't get back to its 2006 peak of $80 annual earnings anytime soon -- S&P estimates around $64 for 2010 and $72 for 2011. But compared to where we were last year, it's a definite step forward.

Bloomberg believes that further dividend increases are likely on a number of fronts. It expects double-digit dividend growth from McKesson (NYSE: MCK  ) and Chesapeake Energy (NYSE: CHK  ) , and overall believes that nearly two dozen stocks will likely increase their dividends during the quarter.

Problems ahead?
From an earnings perspective, then, it looks like clear sailing for dividend investors. Unfortunately, there's a storm brewing on the horizon that could throw a wrench into the mix.

In just eight months, the current favorable 0% and 15% tax rates on dividend income are set to expire. Without action from Congress, those rates will disappear, and investors will have to pay their normal marginal tax rate on their dividend income. After years of relief, that would fully restore the double-taxation on corporate dividends -- a treatment that many argue is unfair, since companies already pay corporate taxes on their profits before making payouts to shareholders.

Before these favorable rates came into effect, dividends had been in decline. Many companies decided that using alternative methods of returning capital to shareholders, including share buybacks, was more efficient from a tax standpoint. Yet after the reduction in tax rates, dividend yields bounced, and shareholders who needed cash from their investments could once again use dividends as part of their overall strategy for generating income.

The administration has targeted tax increases at those with more than $200,000 to $250,000 in taxable income. Yet even if higher rates are limited to upper-income taxpayers, it could spark a reversal in corporate dividend policy that would once again push companies away from paying dividends. That, in turn, would leave income-hungry investors little choice but to sell stocks and seek other ways of finding the cash they need.

Watch closely
Positive dividend news has helped support the year-long rally. But it's a fragile thing, especially given potential adverse changes to taxes on dividends. Unless Congress acts, dividend-sensitive investors need to take the recent good news on the dividend front with a grain of salt. It's entirely possible that a tax hike could yank away the punch bowl before the party really gets started.

Some stocks have what it takes to give you income year in and year out. Find out from Fool contributor Ilan Moscovitz which three stocks will be dividend dynamos.

Fool contributor Dan Caplinger looks for the dividend in every situation. Both he and the Fool own shares of Chesapeake Energy, which is a Motley Fool Inside Value recommendation. McKesson is a Motley Fool Stock Advisor selection. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy always likes getting back in the saddle again.


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