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The prices of dividend-paying stocks have been getting hammered in the marketplace as of late and I expect this category of stocks to struggle in terms of total return for the next couple of years. Some investors may not care about stock price volatility or total-returns during this time span. To those who do, this essay will describe why tough times are likely ahead for dividend stock investors.

I am going to describe three possible macroeconomic and financial scenarios:

1. Pollyanna Scenario: Rate normalization and restored high growth.

This is the most optimistic of all scenarios. In this case, inflation, real interest rates, nominal bond yields and real GDP will gradually rise to "normal" levels: 2.5%-3.0% inflation, 2.0%-2.5% real yield, 4.5% to 5.5% nominal bond yields on 10Y US Treasuries and 2.5%-3.0% real GDP growth. Note that in this scenario, US real GDP will return to an optimistic long-term trend growth rate average (full-cycle) of around 2.5%-3.0%, despite the huge increase in long-term interest rates. Note that this assumes that everything goes "back to normal" despite the huge debt overhang accumulated in the past 30 years and significantly deteriorated demographics. Under this "best of all worlds" scenario, it must be assumed that factors such as greater energy independence and unprecedented productivity and technological advancement will compensate for the negative impact of deleveraging (or slower growth of debt), slower growth of the productive work force and higher dependency ratios.

In this highly optimistic scenario, rates will inevitably rise to the "normal" range of 4.5%-5.5% given this restored level of nominal and real GDP growth. In this scenario, we shall assume that the normalization of interest rates is engineered flawlessly by the US Fed, and perfectly adjusted to by financial markets such that it all occurs in a gradual and orderly fashion that does not disrupt financial markets or the economy at large.

In this scenario, there is precious little room for the stock prices of dividend yield-oriented stocks to rise in the next few years. For example, the S&P High Yield Dividend Aristocrats Index and related ETFs such as SPDR S&P Dividend (NYSEARCA:SDY) are currently yielding around 2.8%. With long-term interest rates expected to rise to 4.5% to 5.5%, the dividend yield on these stocks, if anything, can be expected to rise. This implies that stock appreciation will be limited to the long-term rate of dividend growth at best (generally less than 5%) and/or that stock prices will fall such that the rise in dividend yields follows the path of the rising long-term bond yield.

Furthermore, if we look at dividend stocks on other metrics such as P/E ratios, the most reasonable expectation would be that they would revert from currently very high levels to more "normal" levels. Thus, the stock prices of dividend stalwarts in the utilities sector such as Duke Energy (NYSE:DUK) and the consumer staples sector such as Johnson & Johnson (NYSE:JNJ) that are all currently trading at P/E ratios of above 20 should be expected to either decline or stagnate such that P/E ratios revert to more normal levels of around 14 times earnings or even below.

Finally, in this Pollyanna scenario of restored strong growth, a "rotation" should occur such that the valuations of low-growth dividend sectors that are currently overvalued by historical standards decline relative to the valuation of non-dividend growth sectors that are currently undervalued by historical standards. As risk aversion declines in the Pollyanna scenario, this sort of rotation and arbitrage leading to shifts in relative sector valuations is to be expected.

2. Cassandra Scenario: Interest Rates Spike, Growth Is Derailed

The most pessimistic scenario is that the US Fed will not be able to smoothly engineer a normalization of long-term market interest rates and that halting attempts to do so will create instability and dislocations in financial markets and the real economy.

Under this pessimistic scenario, two types of problems can arise.

In one set of circumstances, credit markets may be destabilized as too many market participants try to get out of low yielding fixed-income instruments at the same time. Under this scenario, rates will tend to spike, negatively affecting real economic activity and corporate earnings growth. This scenario is compatible with a "flailing" Fed that is intermittently forced to backtrack from withdrawal of accommodation and then to resume tightening as various asset markets heat up. In this scenario, GDP and earnings growth will be low to negative causing stock prices in all sectors to suffer.

Another set of circumstances would involve the Fed being altogether too timid in withdrawing monetary accommodation. This scenario, akin to what occurred in the 2004-2005 period, would likely result in the formation of damaging asset bubbles and/or inflation. The bursting of asset bubbles and/or the unwinding of inflation would involve economic crises of the sort experienced in the 2008-2009 period - with the proviso that new crises would be likely be worse given the enormous public debt loads that have been accumulated since the last crisis. New crises would probably entail the emergence of serious sovereign default and/or inflationary risks.

In this scenario, all stock prices - including dividend stock prices - will tend to rise in the short-run and then collapse. A hyper-inflationary scenario might involve a more permanent rise in nominal stock prices. But if you are betting on hyperinflation, you will be better off buying TIPS or gold instruments such as (NYSEARCA:GLD). In such a scenario, stock prices will likely fall in real (inflation adjusted terms) whereas TIPS and gold (to a lesser extent) will preserve their purchasing power. Furthermore, if you are betting on a stock-market bubble, you would be better off purchasing growth stocks and speculative-type stocks, as these are likely to outperform dividend stocks in this environment.

3. Muddle-through. Rates rise in fits and starts, growth sputters.

This scenario is somewhere between the extremes outlined in the two prior scenarios. In this situation, financial markets and the Fed will tend to flail around as they each try to out-guess and adjust to each other. Market rates will tend to spike on any hint of Fed "tapering" and/or eventual tightening. The Fed will jawbone and otherwise take action to try to head off such spikes in rates. In so doing, monetary accommodation will generally remain loose, enabling the formation of asset bubbles and/or inflation, which are later discounted by markets via higher market interest rates. Again, the Fed tries to head this off via jawboning and/or other actions.

In this high-stakes game of chicken, the Fed may ultimately succeed in shepherding unruly financial markets and the economy back onto a normal path. But make no mistake: There will be a cost to pay in terms of macroeconomic volatility and growth. Just as certain economic benefits were derived from Fed accommodation in a crisis scenario, certain economic costs will be incurred as the Fed normalizes monetary policy. There is no free lunch.

A scenario of heightened macroeconomic volatility and below-trend growth is not a recipe for strong stock price appreciation. To the contrary, it is a recipe for low to negative stock returns.

In terms of dividend stocks, this scenario inevitably implies higher interest rates as in scenario #1 - albeit in a more halting fashion. It also implies meager earnings growth due to sputtering economic activity. In other words, dividend stocks get a "double-whammy." In this scenario, very little price appreciation can be expected of dividend stocks. To the contrary, this scenario is compatible with significant P/E contraction and dividend yield expansion as interest rates rise and earnings growth estimates are downgraded.

Conclusion

Between July 2011 and August of 2012, I recommended that investors be very cautious about equity allocations given the extraordinary risks that were faced during that time. However, during that time, I was also consistently of the view that dividend stocks were the best place to be if you were going to be invested in equities at all. Since August of 2012, I have been fairly sanguine about the prospects for all stocks including ETFs such as SPDR S&P 500 (NYSEARCA:SPY). However, in my 2013 outlook piece, I did warn that dividend stocks would likely underperform in 2013 and that risks would rise as we moved further into the year and central bank tapering began.

It is currently my view that despite their recent correction, dividend yield-oriented stocks are relatively unattractive and will remain so for at least a couple of years. In a stock market bubble scenario, these stocks will underperform. In virtually all other scenarios, absolute total returns for these stocks are likely to be modest to negative.

With yields on "high" dividend stocks at near-record lows and P/E ratios near record highs in this segment, there is not much room for price appreciation amongst dividend stocks in the next few years. Under any scenario of "normalization," long-term interest rates will rise significantly, implying rising dividend yields and falling P/E ratios. This suggests poor total returns for dividend stock investors during this period of normalization.

If you think rates won't normalize then you should consider two scenarios. In the first scenario long-term interest rates fail to rise because growth is slow to negative. That is bad for all equities, including dividend stocks.

In the second scenario, interest rates that remain too low for too long will enable asset bubbles. But if you want to speculate on the formation of a stock market bubble, dividend stocks are an inferior vehicle to do so - buy alternative energy stocks, tech and financials.

Either way, sitting around and collecting annualized dividends of 2% to 5% for a couple of years at a time when highly volatile markets are increasingly likely to subtract that much off of the value of those investments in one or a few trading sessions is not an attractive proposition, unless you make some pretty unlikely assumptions about how the economy and financial markets are likely to evolve in the next few years. I will discuss potential alternatives for both income and growth investors in future articles.

Source: Dividend Stocks: Lose-Lose-Lose Proposition In Intermediate Term