Warning: Bubble in High Dividend Stocks Forming

Something odd is happening to high dividend stocks in 2016, and it may be a sign that a new stock market bubble is forming. 

The highest paying dividend stocks are typically utilities, telecoms and consumer staples companies that generate reliable, predictable cash flow month after month, quarter after quarter.

The predictability of monthly utility bills and consumer spending on essentials like toothpaste means these companies can pass a large proportion of their revenues on to investors. They make great income investments, but they usually don’t grow very fast, and their stocks are pretty sedate. 

This year, something different is happening. 

Utilities have been the best-performing stock market sector so far this year, rising nearly four times as much as the S&P!

Consumer staples stocks have also been standouts, rising 10.3% vs. the S&P 500’s 5.6%. From telecoms to tobacco, boring, high-dividend-paying stocks have trounced the broad market so far in 2016. 

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This has led to some pretty out-of-whack valuations in these sectors. The utilities in the S&P 500 currently trade at an average P/E of 19.5, 30% higher than their historical average. 

So is there a new stock market bubble forming in high dividend stocks, or are these sectors’ unusually high valuations deserved? 

Stock Market Bubble or New Normal? 

In a Monday Financial Times article, BlackRock allocation expert Russ Koesterich provided two justifications for the unusually high valuations of utilities today. “The re-pricing of the sector is arguably being driven by two, interrelated trends,” he said, “a preference for low-beta, less volatile stocks and a thirst for income.” 

In other words, investors are seeking safety and yield, two things utility stocks excel at providing—and that, crucially, are hard to find elsewhere today. Interest rates in the U.S. are at historical lows, making treasury bonds—long the default investment for safety and yield—both unappealing and low yielding. 

In fact, the number of S&P 500 stocks with dividends higher than the 10-year treasury yield is at a historic high today. As interest rates have declined since 2008, the number of stocks meeting this criterion has exploded, skyrocketing from fewer than 5% in 2007 to over 50% today. 

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In other words, dividend stocks are a better income investment than fixed income today! 

Utilities currently yield a solid 3.2% on average, while telecoms pay even better, averaging 4.3%. The yield on the 10-year U.S. Treasury is below 1.6%. Multiple interest rate hikes will be necessary before 10-year Treasury Bills become competitive with utilities or telecoms. And as of the end of last week, the Fed Funds futures market puts the chance of a rate rise by the end of the year at only 33%—and that’s the chance of one single rate hike of one-quarter percent. 

As Mr. Koesterich told the Financial Times, “As long as we remain in an environment characterized by ultra-low interest rates, investors may be more willing to pay a premium for companies that can deliver a relatively secure income stream.” 

Bubble in Dividends? 

A warning though: Even if high dividend stocks’ valuations are sustainable, investors’ insatiable appetite for dividends is still causing market distortions. 

In addition to driving up stock prices, investor demand for high dividends may be directly affecting companies’ dividend policies.
Dividend-paying stocks’ payout ratios have been rising for the past two years, and are now at their highest level since 2009. Dividend payout ratios represent the share of earnings that a company pays out as dividends. Very slow-growth companies like utilities can often afford to send over half of their cash flow directly to investors, but faster growth companies should reinvest more of their profits in their business so they typically have lower payout ratios. 

The chart below shows payout ratios of S&P 500 companies averaging between 30% and 40% for most of the post-financial crisis decade, before beginning to creep up in late 2014. Today, payout ratios are averaging above 50%, their highest level since 2009, as companies divert more and more of their cash flow to investors. 

In other words, S&P dividend payers are now sending over fifty cents of every dollar of EPS directly to investors. 

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This isn’t necessarily a problem; if investors are signaling to company boards (which set dividends) that they think dividends are the best use of cash right now, and the boards agree, you could consider this a triumph of the free market. But given the simultaneous surge in interest in dividend stocks, it’s also possible that boards are trying to attract investors—and “artificially” inflate their stock prices—by paying higher dividends than they would otherwise. 

If that means cash that should be spent on investment, R&D or growth is being sent to investors instead, it will cause serious challenges for these companies down the road. (Suspending or reducing dividends is usually severely punished by the market, so these companies are all but locked into keeping dividends at or above these levels going forward.) 

So What Should You Do with Your Dividend Stocks? 

On one hand, the high valuations of dividend payers may be here to stay. 

On the other hand, there could be a separate bubble forming in dividend payouts themselves. 

And of course, there’s the fact that there are really no viable alternatives to dividend stocks for income today. 

There are two things I wouldn’t do: 

1) I wouldn’t sell your outperforming high dividend stocks today. Utilities and other ultra-conservative dividend stocks will eventually fall out of favor, but I don’t want to be the investor trying to pick the top. The experts thought utilities were overvalued back in April, when they were up 15% for the year, and they’ve continued to outperform the market since then. 

2) I wouldn’t buy overvalued utilities today. Even with interest rates still in the basement, a rising market and improving investor sentiment are likely to make utilities and other conservative investments less attractive over time.

The high demand for dividends plus a new bull market may make it hard to see exactly when the rotation out of utilities begins, because they’ll simply underperform rather than crash.

But if the market is zooming ahead, there’s no reason you should tie up your cash in overvalued, underperforming utilities.

Since the post-Brexit rally began on June 28, the S&P 500 (SPY) is up 8%, the Consumer Staples sector (XLP) is about 5% higher and the utilities sector (XLU) has risen 2%. That doesn’t exactly sound like a bubble bursting, but it is underperformance, and in a bull market, it could signal rotation.

In Cabot Dividend Investor, we have 50% profits in both of our utility stocks, and both are rated Hold. I think that’s the appropriate rating today.

So what would I do if I wanted to add a dividend-paying stock to my portfolio today? I’d look for high dividend stocks that remain reasonably valued, and perhaps have even underperformed the market over the past six months.

Three stocks come to mind, all Cabot Dividend Investor recommendations. 

One is a discount retail chain that has increased its dividend every year for 12 years, and often pays hefty special dividends too.

One is a major U.S. automaker that’s been putting up record sales numbers but is so unloved by investors that its P/E ratio is lower than its yield!

And one is a 2.5%-yielding blue chip in a sector that’s underperformed the market for over a year and is just starting to rebound.

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Today is a fantastic time to be a dividend investor, but it’s also a complicated time. As we’ve seen this year, even “widow and orphan” stocks aren’t what they used to be! But Cabot Dividend Investor and my Individualized Retirement Income System (IRIS for short) can still make income investing both simple and profitable. Just click here to learn more.

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