Implied Dividends and Market Optimism
Implied dividends of European stocks based off of dividend swaps on the DJ Eurostoxx 50 index, have jumped, indicating growing optimism about equity markets worldwide.
Implied dividends were at distressed levels near the end of Q’4 last year. The cause was a scramble by dealers to hedge their long dividend exposures. Worsening dividend forecasts combined in a perfect storm as natural counter parties willing to take on long exposures, hedge funds, were taken out on stretchers. Dealers are generally long dividends because of the equity structured products they sell, which tend to be bullish. However, dealers’ need to unload dividends as decreased dramatically due to positive performance in equity markets and a lack of negative earnings surprises.
There has been a re-rating of dividends as forced selling caused a dislocation between the performance of the equity markets and their corresponding dividend markets because dividends were more aggressively impacted. The recent alleviation of several outlier events, namely the forced selling of long dividend positions by market participants as well as less extreme market conditions, forced dealers and hedge funds that participate in this market to realize just how big a discount implied dividends were trading at versus underlying stock fundamentals. It didn’t take a PhD to realize implied dividends were compressed much more than they should have been. Because dividends have a delta to the underlying equity markets, implied dividends track their performance.
It appears dividends have returned to fundamental levels but there is still room for dividends to rally further, lacking some multi-sigma event on the horizon as any potential dividend upside remains coupled to a sustained rally in equity markets.
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