“The top-yielding stocks in the S&P 500 Index still look fairly attractive relative to stocks with lower yields. Click on the thumbnails below to see our charts. On average, stocks in the highest-yielding quintile tend to be cheaper. The second and third quintiles also seem reasonably valued, while the two quintiles with the lowest yields are pricey on most metrics. However, viewed through the prism of history, high-yielders look more expensive. The highest-yielding stocks average Quadrix® Value scores of 56—not bad, but well below their averages of 65 over the last five years and 71 since 1994.
“Since top-yielding stocks have historically traded at a discount, investors shouldn’t expect their valuation ratios to rise to match those of lower-yielding stocks any time soon. And based on price/earnings, price/cash flow, and price/sales ratios, the average stock in the top quintile of the S&P 500 on yield is more expensive today than its average valuation since 1994.
“In contrast, stocks in the three quintiles with the lowest yields tend to trade at discounts to their average valuations since 1994. Stocks of all stripes look expensive relative to five-year averages, but none of the other four quintiles saw their valuation ratios expand as much as the high-yielders did.
“When you reach beyond value, high-yielders don’t measure up. The top quintile of S&P 500 dividend- payers based on yield averages a Quadrix Overall score of 47, the lowest of any quintile. In fact, high-yielders are also at the bottom of the pile in Quadrix Momentum, Quality, Financial Strength and Performance. …
“Subpar fundamentals aren’t the only cause for concern about dividend stocks. While high-yielders have been outperforming for more than three years, the excess returns have eroded in recent months. During the last dozen rolling 12-month periods, high-yielders’ outperformance has averaged just 0.4%. These stocks also face some political risk, though in this case perception is worse than reality. The Bush tax cut on dividend income is set to expire next year, which has plenty of investors spooked. If the tax cut isn’t renewed, dividends will be taxed at ordinary-income rates instead of the current 15% maximum. However, pundits calling for a bloodbath in dividend stocks are probably overstating the case.
“First, a cold-turkey cutoff of the tax break is far from certain, even if Obama wins the election. Second, dividend stocks have performed well even during periods when tax rates were higher. They could show some short-term weakness in the event of a tax increase, but the long-term appeal of income is unlikely to erode.
“The Forecasts likes dividend stocks, but we have historically advised readers not to chase the highest yielders. Given the weak Quadrix scores and mixed valuation trends for high-yield stocks, our advice has not changed. That said, we cover plenty of reasonably valued stocks with robust dividends. We advise income investors to focus on solid stocks with attractive valuations. Seek out companies capable of growing both profits and dividends over time.”
Richard J. Moroney, Dow Theory Forecasts, October 8, 2012