High dividend stocks and ETFs have been in a correction mode lately, because of the 'Dividend Cliff' -- the prospect of a sharp decline in after tax dividend payoffs due to a large increase in dividend taxes in 2013, should the 2001 Bush tax cut on dividends be allowed to expire.
This correction is an overreaction, however.
Even if the Dividend Cliff happens, it won't diminish the appeal of high dividend stocks and ETFs.
With the Fed keeping interest rates at record low levels, buying high-dividend paying stocks has been a popular trade among retail investors during the last two years. As I wrote in an article I co-authored for Barron's recently, this is a risky strategy, especially for investors using borrowed money to finance this trade.
Trading Direct, for instance, lends investors who are willing to assume a heavy debt load at a variable rate of 1.25%. This means that these investors can secure a gain of 2.63% by investing the money in a utility ETF like Utilities Select Sector SPDR (NYSEARCA:XLU) and a 4.25% gain by investing in a tobacco company like Altria Group (NYSE:MO).
On the surface, this game seems like printing money. Investors who have been playing this game for the last two years have benefited in two ways: First, from both the "spread," the difference between the dividend rates and the margin borrowing rate. Second, the appreciation in the price of these stocks, which ranges anywhere between 18% and 36%, compared to 16% for the S&P 500.
But on closer examination, this is a high-risk game -- for two reasons. First, it pushes the price of these stocks way above their fair value, e.g., the price warranted by economic and business fundamentals. Utilities and tobacco are usually slow-growth industries - Southern Company's (NYSE:SO) revenue, for instance, grows at 3% but trades at a P/E of 19.29 compared to around 13 for the S&P 500.
Second, as more and more investors chase after these companies, pushing their stock prices higher, the "spread" narrows, making them less appealing, and the trade becomes crowded. Two years ago, for instance, XLU's yield was close to 5%, while now it is well below 4%.
In the last two weeks, investors already got a taste of the severity of these risks, as high-yield ETFs and stocks began to face the music of the dividend cliff. XLU, Southern co, Consolidated Edison (NYSE:ED), and American Electric Power (NYSE:AEP) lost all the gains for the year and then some. Hurricane Sandy has also hurt utilities in the Northeast.
But there is no reason for panic- at least not yet- for two reasons.
First, any rise in dividend tax won't diminish the appeal of dividend stocks, as the spread between what money earns in the bank and what dividend stocks pay is still significant -- especially after the recent correction in the value of these stocks.
Second, as long as the Federal Reserve is on an easing mode, interest rates aren't expected to rise significantly to diminish the dividend advantage over bank deposits.
A few words of caution: A low interest/low tax environment may diminish market risk, but not company and industry-specific risk. Complacency should never be a substitute for due diligence.
Disclosure: I am long AEP, XLU, SO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.