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Many investors own high dividend-yielding stocks not only for the income that they produce but because of the presumed defensive characteristics of these stocks. It is widely believed that a high divided yield essentially “protects” a stock against general market declines.

This has historically been true, for the most part, in terms of relative performance. Indeed, during the recent market decline, although high-dividend yielding stocks have declined in value substantially in absolute terms, they have still outperformed the general market (NYSEARCA:SPY) handily.

However, there is reason to believe that if the current correction turns into a more intense sell-off, that high dividend yielding stocks in such traditionally defensive sectors as MLPs, income trusts and income-oriented closed-end funds could face a devastating collapse. Examples of some vulnerable stocks might be EEP, KMP, PGH, ERF, FOF and ZTR.

There are three reasons for this:

UNWINDING OF LEVERAGED INCOME-PRODUCING STRATEGIES

Hedge funds, mutual funds and individuals have been employing leveraged strategies employing normally low-beta high divided paying stocks in order to maximize income.

One popular leveraged strategy is simply to buy dividend-producing stocks on margin. With margin interest rates below 1%, buying high yielding dividend stocks has appeared to be as easy as “printing money.” The problem is that if stock prices drop sharply, investors will be forced to liquidate positions, either due to margin calls or due to stop losses.

Another increasingly popular strategy to maximize income has been to sell naked puts and calls with strike prices below and above the current share price. The problem is that such a strategy can prove deadly, producing margin calls and forced liquidation if the price of the stock drops swiftly.

ROOKIE INCOME INVESTORS MAY PANIC

Many traditional fixed income investors have been lured into high dividend yielding stocks simply because the dividend yields offered on stocks in sectors such as MLPs, income trusts and closed-end high-distribution funds are substantially higher than those offered by fixed income securities.

The problem is that most of these former fixed income investors are not used to handling stock market volatility. That is precisely why they were formally invested in fixed income in the first place.

Many of these former fixed-income investors will not handle volatility well and will liquidate positions in a panic if the principle value of their holdings decline below their cost basis.

DIVIDEND STOCKS GROSSLY OVERVALUED ON A RELATIVE BASIS

Never before modern history of the US stock market have dividend producing stocks been so overvalued relative to the market as a whole and growth stocks in particular. Many factors discussed here have been driving this anomaly. This relative overvaluation has reached almost bubble-type proportions.

For example, it is common for stocks in the MLP and income trust sectors to sport PEs in the 20s. By contrast, quality US growth stocks such as AAPL are trading at forward PEs in the low teens and some quality growth stocks like ORCL and SNDK are trading at forward PEs in the single digits.

Given average growth rates of zero and even negative in sectors such as the MLPs, income trusts and high-distribution closed-end funds, such a valuation discrepancy is absurd. While the PEGs of high-growth tech stocks in the US are consistently below 1.0x, the PEGs of high-dividend producing sectors are consistently between four and infinity. There is no question that this enormous anomaly will correct itself in time. And in a bear market, such an anomaly will tend to correct itself through the relatively overvalued stocks collapsing to the downside in absolute terms.

CONCLUSION

Dividend income investors should beware. In the event of sharp stock market declines, stocks in high-dividend yielding sectors such as MLPs, income trusts and high distribution yield CEFs are vulnerable to a very nasty collapse.

Investors should recall the frightening collapse that occurred in 2008 and 2009 in these traditionally defensive sectors.

While one might ordinarily be inclined to think that such an occurrence could not repeat itself, the fact is that the thirst for yield has increased the risk profile of the asset class both in terms of the types of investors holding these stocks as well as the leveraged strategies being employed by the holders. Furthermore, the level of overvaluation of these sectors relative to the market as a whole, and growth stocks in particular, is much greater today than it was in 2008-2009.

Source: High Dividend Stocks Generally Facing Massive Liquidation and Collapse