Are Dividend Stocks in a Bubble?

by Daniel Putnam | October 22, 2012 10:29 am

Ever since the technology bubble popped in the last decade, it takes little more than a few months of strong performance for a given asset to bring out the hordes of pundits screaming “bubble!” Type “stock bubble” into Google Search, and it brings up 95,500,000 results. “Bond bubble?” You’ll get a comparatively small 41,400,000.

Among the more recent asset classes to come into the cross-hairs of the bubble crowd are dividend-paying stocks[1], which have drawn more than their share of negative attention of late. Unfortunately for the bears, the concept of a dividend bubble just doesn’t pass the smell test.

But that doesn’t mean high-dividend stocks aren’t overvalued.

Not a Bubble …

We all know the story by now: In the era of low bond yields, investors are moving out the risk spectrum to find income.

That might be true to some extent, but in the past year the 22.1% return for iShares Dow Jones Select Dividend Index Fund (NYSE:DVY[2]) is actually behind the 23.9% return of SPDR S&P 500 ETF (NYSE:SPY[3]). DVY has a substantial edge on a three-year basis — with an average annual total return of 15.66% versus 12.43% for SPY — but this isn’t a margin out of outperformance that could legitimately be termed a “bubble.”

In short, if dividend stocks are in a bubble, the same should be said for the entire stock market.

… But Certainly Overpriced

Instead, it might be more accurate to say that dividend stocks are very richly priced.

According to the SPDR website, SPDR S&P Dividend ETF (NYSE:SDY[4]) — which tracks the S&P Dividend Aristocrats Index[5] — has a trailing P/E of 17.1 and a forward P/E of 15.3. SPY, in contrast, has a trailing P/E of 15.4 and a forward P/E of 14.

SDY’s higher valuation would be understandable if the growth rate of its underlying components were higher, but that’s not the case: SDY’s components sport estimated three-to-five-year EPS growth of 8.4%, well below the 10.5% for SPY.

For all of this, SDY’s trailing yield of 3.2% is not far above the 1.9% of SPY. This indicates that investors are willing to pay through the nose for an extra 1.3 percentage points worth of yield and an element of safety. But can any stock — or group of stocks — trading at the high end of this historical range truly be considered safe?

Does Valuation Matter?

The answer to this one is “It depends.” If economic growth suddenly accelerates and investors begin to gravitate toward high-growth names, it’s reasonable to expect that dividend-payers would lag in the subsequent rotation.

On the other hand, a downturn in the market should result in outperformance — though not absolute gains — for the type of large, cash-rich and defensive companies that populate the high-dividend universe. In this scenario, safety trumps valuation. This was evident on Friday, when the S&P shed 1.66% but DVY fell only 1.32%. If the market maintains its downtrend, expect more of the same.

Bonds Are the X-Factor

An additional consideration right now is that dividend stocks tend to have a higher correlation with U.S. Treasury yields than the rest of the market.

Since its inception in November 2003, DVY has had a correlation of 0.16 with the 10-year Treasury yield, well above the SPY’s correlation of -0.13.* And in the past three years, DVY has registered a whopping 0.8 correlation with iShares Trust Barclays 20+ Year Treasury Bond Fund (NYSE:TLT[6]).

These high correlations have been a big plus in recent years, of course, as Treasuries have performed exceptionally well. Now that yields are in the mid-1% range, though, the elevated correlation between dividend payers and bonds might become a negative.

The Bottom Line

Those who already hold individual dividend-paying stocks such as Coca-Cola (NYSE:KO[7]) or Pfizer (NYSE:PFE[8]) likely do so for the long-term stability, and they probably won’t be swayed by concerns about valuation or fluctuations in the bond market. However, those who are looking to build a broader position in the group via ETFs should realize that high-dividend stocks — while certainly not in a bubble — are facing a set of headwinds that weren’t in place when the rally began back in 2009.

*Correlations run on a scale of -1.0 (perfectly negative correlation) to 1.0 (perfectly positive).

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Endnotes:
  1. dividend-paying stocks: http://investorplace.com/2012/10/top-10-dow-dividend-stocks-for-october/
  2. DVY: http://studio-5.financialcontent.com/investplace/quote?Symbol=DVY
  3. SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY
  4. SDY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SDY
  5. S&P Dividend Aristocrats Index: http://www.bloomberg.com/quote/SPHYDA:IND
  6. TLT: http://studio-5.financialcontent.com/investplace/quote?Symbol=TLT
  7. KO: http://studio-5.financialcontent.com/investplace/quote?Symbol=KO
  8. PFE: http://studio-5.financialcontent.com/investplace/quote?Symbol=PFE

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