The Rumor-Bursting Truth About The Dividend 'Bubble'

by: Lou Basenese

The mainstream financial press would like us to believe we're in the middle of a dividend bubble. And the evidence appears to be overwhelming…

"Companies have never paid more dividends than now," said well-known research analyst, Howard Silverblatt, in a MarketWatch article. And he's right.

This year, S&P 500 companies are on pace to pay out a record amount in dividends - $277 million or about $29.02 per index share.

In a Baltimore Sun article, financial planner Denise Leish warns that income-hungry investors have bid up the prices of many dividend-paying stocks. And she's right, too.

In 2011, dividend stocks trounced the 2.1% gain for the S&P 500 Index, rising an average of 8.3%.

Then there's this from the Associated Press: In the last 12 months investors plowed a net $25 billion into dividend focused mutual funds. Yet they yanked $136 billion out of all other stock fund categories. Clearly, dividend investing appears to be the new rage.

I mean, how else do we possibly explain the fact that, according to Morningstar, the number of mutual funds focusing on dividend-paying stocks increased 55% in the last year from 29 to 46? Or the fact that a record 22 new companies in the S&P 500 announced they would begin paying a dividend?

Like I said, given this body of evidence, it's hard not to believe we're in the middle of a dividend bubble.

The only problem? We're only getting half of the story! Today, I want to provide you with the whole truth. And more importantly, remind you of an easy seven-step strategy to make sure you never get burned investing in dividend stocks. Ever.

The First Sign of a Bubble

According to the Congressional Budget Office, an asset bubble forms when "the price of a class of physical or financial assets (such as houses or securities) rises to a level that appears to be unsustainable and well above the assets' value as determined by economic fundamentals."

Sorry folks. Even though dividend stocks rallied four times as much as the average stock in the S&P 500 Index last year, they're not trading at "unsustainable" valuations.

Consider: The Dow Jones U.S. Dividend 100 Index currently trades at a price-to-earnings (P/E) ratio of 13.78 and a forward P/E ratio of 13.79. That's well below the current P/E ratio of 24.99 and forward P/E ratio of 16.33 for the Nasdaq Index.

Even if we evaluate dividend stocks purely on performance, they're clearly not in a bubble.

So far this year, the S&P Dividend Aristocrats Index is up 8.7%. And the broader Dow Jones U.S. Dividend 100 Index is up 6.1%.

That hardly qualifies as runaway performance. Especially when you consider that the Nasdaq Index is up 17.6% in 2012. And the Wilshire 5000 Index - which tracks the performance of all U.S. equity securities, the majority of which don't pay a dividend - is up 11.1%.

Don't Be Fooled By Records, Either

Although S&P 500 companies are going to pay out a record amount in dividends this year - and a record amount of new companies instituted dividends - don't be fooled by so many "records." The truth is, these aren't really records at all…

The $277 million in expected dividend payouts this year only represents 30% of profits. But, historically, S&P 500 companies have paid out 52% of profits in dividends, according to Standard & Poor's data.

In other words, there's much more cash available to keep increasing dividend payouts. And when I say much more, I mean much more. At the end of the fourth quarter, S&P 500 companies were sitting on a record $1 trillion in cash.

There's also room for more companies to start paying dividends, too. Since 1980, an average of 413 companies in the S&P 500 paid a dividend. Currently, the total rests at 397.

Bottom line: As I told you before, dividends account for 90% of total stock market returns. But just because the average investor is finally waking up to this reality, it doesn't mean we're in a dividend bubble.

It just means we need to avoid the dividend yield trap. And instead, be more selective with our investments, by insisting that any potential dividend investment meets these seven criteria.